You can't move these days without bumping into an economic pessimist. "Recession in America looks increasingly likely," said the Economist magazine on Nov. 17. Two days later, in the International Herald Tribune, Nobel Prize winner Paul A. Samuelson brought up the specter of the Great Depression. And then, on Nov. 26, former U.S. Treasury Secretary Larry Summers wrote in the Financial Times that, "the odds now favor a recession that slows growth significantly on a global basis."

The pressure on policy makers to do something is intense. Not only is there a desire to see the government get even more involved in the housing loan market -- witness the Bush administration's plan to freeze starter rates -- there is also tremendous pressure on the Fed to make another large 50 basis-point rate cut in attempt to alleviate credit-market problems.

This desire for government intervention to fix problems that grown adults have created for themselves is dangerous. Constantly counting on the government to save the economy undermines confidence in free markets, conditions people to believe they don't have to live with bad decisions, and creates a willingness to take imprudent risk. Actions to stabilize the economy in the short term can destabilize it in the longer term, and set the stage for even more intervention to fix the new problems at a later date.

Moreover, all this pessimism makes serious economic problems less likely. If it really happens, a recession in the next year could be the most anticipated ever. That fact alone makes it improbable. Recessions usually surprise the consensus. When a recession is expected, the odds of rapidly rising inventories, excessive investment, or a surprise drop in new orders are reduced.

In the past, when manufacturing was a larger share of the economy and inventory control was less exact, recessions often began abruptly, sometimes on the heels of very strong growth. Today, with services a larger share of the economy, and technology speeding up information flow, the economy tends to glide more gently into recession. Given this, all the doom and gloom seems unnecessary.

Real GDP in the U.S. grew 4.9% at an annual rate in the third quarter, and has averaged 4.4% in the past two quarters. While real growth in the current quarter will slow (our forecast is 1.5% to 2.0%), this is more of a payback for the past two quarters of strong growth than it is a new direction for the economy. Average annualized growth in real GDP from March to December will be roughly 3.5%.

In addition, nominal GDP, or total spending, has accelerated from a 3.6% annual growth rate in the second half of 2006 to 6.2% in the past two quarters. This is an excellent signal that Fed policy is still accommodating. When the Fed is tight, the growth rate of nominal GDP, or aggregate demand, does not accelerate.

Despite all of this, many believe that credit-markets problems have increased economic risk dramatically. Mr. Summers argues that "levels of the federal-funds rate that were neutral when the financial system was working normally are quite contractionary today." "Speculative markets will not stabilize themselves," wrote Paul Samuelson. For Messrs. Summers and Samuelson, only Fed action can save the world.

But this argument confuses money and credit. It is increases in the money supply that drive total spending (or aggregate demand), not increases in credit. Many people confuse the idea of a "money multiplier" with money creation. They believe banks can create money. This is not true: The Fed is the only entity in the world that creates new dollars.

In a fractional reserve banking system, the money multiplier works as banks lend out part of their deposits and keep some in reserve. Then the next bank, which receives deposits as a result of the first bank's loan, lends out part of the money again. This is repeated over and over so that every dollar of the monetary base is "multiplied" into many more dollars of lending or credit.

Despite problems at many major financial institutions, this process is not breaking down. The Fed is not behind the curve. When the Fed buys bonds to inject new liquidity into the banking system, that money doesn't go into a black hole. Even if a bank has had its capital eroded by large write-downs, it must invest the new cash. Some banks are putting the cash right back into Treasury bonds, which is one reason Treasury yields are so low. Banks need less capital to hold Treasury bonds than they need to hold loans to the private sector.

But, contrary to popular belief, when a bank buys Treasuries, the money mechanism does not stop. For every debit there must be a credit, and this continues endlessly. In fact, it may be that banks are buying those Treasury bonds from foreign holders, say the Abu Dhabi Investment Authority, which just made a huge investment in Citibank. In this case, the money came right back into the U.S. banking system.

There are an infinite number of paths that the monetary transmission mechanism can take. The only time it breaks down is when investors expect deflation, as in the Great Depression. This is when hording cash makes sense. But this is not the case today. Consumer prices are up 3.5% versus last year. As a result, as long as the Fed is accommodative, money will find its way into the financial system and the multiplier process will continue.

This does not require massive money center banks such as Citibank. It can happen through any well-capitalized institution. For example, tens of thousands of community and regional banks made few or no subprime loans and have large amounts of excess capital. They are in fantastic shape. However, because the cost of funds for banks does not fall quickly, and adjustable rate loans reset immediately, a rate cut can hurt these banks' earnings. In addition, with uncertainty about the economy elevated, forcing banks to lend at lower rates doesn't make sense. Widening spreads between Treasury and private-sector bond yields are a signal that the federal-funds rate is too low, not too high. This helps explain why many regional Federal Reserve Bank presidents sound hawkish.

Hedge funds, private equity firms and nonfinancial corporations also have trillions in cash that is already being put to work. Citadel, a hedge fund, bought at-risk loan pools from E*Trade, and increased its investment stake by $2.5 billion. The French parent of CIFG Services Inc., a major bond insurer, injected $1.5 billion of new capital to shore up its balance sheet. Bank of America invested in Countrywide and HSBC brought its high-risk loans back onto its balance sheet.

The only real problem is that these "fixes" are not cheap. Citibank is paying 11% to Abu Dhabi. E*Trade reportedly sold its problem loans to Citadel for 27 cents on the dollar, a price many think is well below the true value. Institutions with cash and capital will make huge profits in this environment, while those without these two things will fight to survive. While not everyone is happy about it, the market is healing itself.

Some say that we can't risk a spillover of credit problems into the economy as a whole, but that ignores two things. First, outside of housing-related businesses and financial institutions that invested in subprime securities, the economy is in good shape. Despite many months of fearful forecasts and an erosion in consumer confidence, the economy remains resilient. Early holiday shopping data have been strong, car and truck sales rose in November and manufacturing continues to expand.

Second, more Fed rate cuts risk a weaker dollar, rising inflationary pressures and a new round of lax lending standards. Don't forget that similar arguments were used between 2001 and 2004 to justify a 1% federal-funds rate that was designed to ward off the significant and serious risk of deflation. That policy helped create the subprime lending crisis in the first place.

To top it off, as long as the Fed allows the market to believe more rate cuts are coming, the greater the incentive to put off business activity. An investor who wants to buy distressed property or debt, a potential home buyer, or a hedge fund looking to make a leveraged investment may choose to wait for lower interest rates before taking action. This delays the self-healing process of the marketplace.

All of this argues for a much more laissez-faire approach. Attempting to offset the problems caused by a few (i.e., a bailout), actually creates larger risks for the economy as a whole. The very act of saving the world puts it at greater risk.

Wesbury is right on the money IMO. While I like low interest rates and as an exporter I like a weak dollar, taking the Fed rates to artificially low levels for economic stimulus would be to repeat a pattern that causes them to go up later to punitive levels and risk future stagflation.

The government has other stimulative tools available, not just free money. Legalize energy production comes first to mind. Introduce market reforms into health care. Make the previous tax rate cuts permanent, stable and predictable, not just stimulative. Cut corporate tax rates. At the state level, stop taxing capital gains that include inflationary gains as ordinary income!

The Fed's primary function is to maintain a stable value of the currency, not to attempt to tweak out all the minor ups and downs in the economy. Other than energy, health care and government costs, none of which are dollar-caused problems, price stability has been good.

Stable interest rates are a secondary, but VERY important goal as well. It is bad for the economy to have homebuilding, for example, alternate in boom and bust modes instead of to flourish as an ongoing, profitable industry employing millions.

The Fed was painted into a corner last time when it lowered its rate to 1%. The only step down from there would have been to just give money away. They were out of policy options and admitted later that they don't want to be in that situation again.

Wesbury didn't like the last rate cut and I like rates right where they are now. Let's start solving other problems. - Doug

The Roots of the Mortgage Crisis Bubbles cannot be safely defused by monetary policy before the speculative fever breaks on its own. WSJBY ALAN GREENSPAN Wednesday, December 12, 2007 12:01 a.m. EST

On Aug. 9, 2007, and the days immediately following, financial markets in much of the world seized up. Virtually overnight the seemingly insatiable desire for financial risk came to an abrupt halt as the price of risk unexpectedly surged. Interest rates on a wide range of asset classes, especially interbank lending, asset-backed commercial paper and junk bonds, rose sharply relative to riskless U.S. Treasury securities. Over the past five years, risk had become increasingly underpriced as market euphoria, fostered by an unprecedented global growth rate, gained cumulative traction.

The crisis was thus an accident waiting to happen. If it had not been triggered by the mispricing of securitized subprime mortgages, it would have been produced by eruptions in some other market. As I have noted elsewhere, history has not dealt kindly with protracted periods of low risk premiums.

The root of the current crisis, as I see it, lies back in the aftermath of the Cold War, when the economic ruin of the Soviet Bloc was exposed with the fall of the Berlin Wall. Following these world-shaking events, market capitalism quietly, but rapidly, displaced much of the discredited central planning that was so prevalent in the Third World. A large segment of the erstwhile Third World, especially China, replicated the successful economic export-oriented model of the so-called Asian Tigers: Fairly well educated, low-cost workforces were joined with developed-world technology and protected by an increasing rule of law, to unleash explosive economic growth. Since 2000, the real GDP growth of the developing world has been more than double that of the developed world.

The surge in competitive, low-priced exports from developing countries, especially those to Europe and the U.S., flattened labor compensation in developed countries, and reduced the rate of inflation expectations throughout the world, including those inflation expectations embedded in global long-term interest rates.

In addition, there has been a pronounced fall in global real interest rates since the early 1990s, which, of necessity, indicated that global saving intentions chronically had exceeded intentions to invest. In the developing world, consumption evidently could not keep up with the surge of income and, as a consequence, the savings rate of the developed world soared from 24% of nominal GDP in 1999 to 33% in 2006, far outstripping its investment rate.

Yet the actual global saving rate in 2006, overall, was only modestly higher than in 1999, suggesting that the uptrend in developing-economy saving intentions overlapped with, and largely tempered, declining investment intentions in the developed world. In the U.S., for example, the surge of innovation and productivity growth apparently started taking a breather in 2004. That weakened global investment has been the major determinant in the decline of global real long-term interest rates is also the conclusion of a recent (March 2007) Bank of Canada study.

Equity premiums and real-estate capitalization rates were inevitably arbitraged lower by the fall in global long-term interest rates. Asset prices accordingly moved dramatically higher. Not only did global share prices recover from the dot-com crash, they moved ever upward.

The value of equities traded on the world's major stock exchanges has risen to more than $50 trillion, double what it was in 2002. Sharply rising home prices erupted into major housing bubbles world-wide, Japan and Germany (for differing reasons) being the only principal exceptions. The Economist's surveys document the remarkable convergence of more than 20 individual nations' house price rises during the past decade. U.S. price gains, at their peak, were no more than average.

After more than a half-century observing numerous price bubbles evolve and deflate, I have reluctantly concluded that bubbles cannot be safely defused by monetary policy or other policy initiatives before the speculative fever breaks on its own. There was clearly little the world's central banks could do to temper this most recent surge in human euphoria, in some ways reminiscent of the Dutch Tulip craze of the 17th century and South Sea Bubble of the 18th century. I do not doubt that a low U.S. federal-funds rate in response to the dot-com crash, and especially the 1% rate set in mid-2003 to counter potential deflation, lowered interest rates on adjustable-rate mortgages and may have contributed to the rise in U.S. home prices. In my judgment, however, the impact on demand for homes financed with ARMs was not major.

Demand in those days was driven by the expectation of rising prices--the dynamic that fuels most asset-price bubbles. If low adjustable-rate financing had not been available, most of the demand would have been financed with fixed rate, long-term mortgages. In fact, home prices continued to rise for two years subsequent to the peak of ARM originations (seasonally adjusted).

I and my colleagues at the Fed believed that the potential threat of corrosive deflation in 2003 was real, even though deflation was not thought to be the most likely projection. We will never know whether the temporary 1% federal-funds rate fended off a deflationary crisis, potentially much more daunting than the current one. But I did fret that maintaining rates too low for too long was problematic. The failure of either the growth of the monetary base, or of M2, to exceed 5% while the fed-funds rate was 1% assuaged my concern that we had added inflationary tinder to the economy.

In mid-2004, as the economy firmed, the Federal Reserve started to reverse the easy monetary policy. I had expected, as a bonus, a consequent increase in long-term interest rates, which might have helped to dampen the then mounting U.S. housing price surge. It did not happen. We had presumed long-term rates, including mortgage rates, would rise, as had been the case at the beginnings of five previous monetary policy tightening episodes, dating back to 1980. But after an initial surge in the spring of 2004, long-term rates fell back and, despite progressive Federal Reserve tightening through 2005, long-term rates barely moved.

In retrospect, global economic forces, which have been building for decades, appear to have gained effective control of the pricing of longer debt maturities. Simple correlations between short- and long-term interest rates in the U.S. remain significant, but have been declining for over a half-century. Asset prices more generally are gradually being decoupled from short-term interest rates.

Arbitragable assets--equities, bonds and real estate, and the financial assets engendered by their intermediation--now swamp the resources of central banks. The market value of global long-term securities is approaching $100 trillion. Carry trade and foreign exchange markets have become huge.

The depth of these markets became readily apparent in March 2004, when Japanese monetary authorities abruptly ceased intervention in support of the U.S. dollar after accumulating more than $150 billion of foreign exchange in the preceding three months. Beyond a few days of gyrations following the halt in purchases, nothing of lasting significance appears to have happened. Even the then seemingly massive Japanese purchases of foreign exchange barely budged the prices of the vast global pool of tradable securities.

In theory, central banks can expand their balance sheets without limit. In practice, they are constrained by the potential inflationary impact of their actions. The ability of central banks and their governments to join with the International Monetary Fund in broad-based currency stabilization is arguably long since gone. More generally, global forces, combined with lower international trade barriers, have diminished the scope of national governments to affect the paths of their economies.

Although central banks appear to have lost control of longer term interest rates, they continue to be dominant in the markets for assets with shorter maturities, where money and near monies are created. Thus central banks retain their ability to contain pressures on the prices of goods and services, that is, on the conventional measures of inflation. The current credit crisis will come to an end when the overhang of inventories of newly built homes is largely liquidated, and home price deflation comes to an end. That will stabilize the now-uncertain value of the home equity that acts as a buffer for all home mortgages, but most importantly for those held as collateral for residential mortgage-backed securities. Very large losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted adjustment, the U.S. economy, and the world economy more generally, will be able to get back to business.

Mr. Greenspan, former chairman of the Federal Reserve, is president of Greenspan Associates LLC and author of "The Age of Turbulence: Adventures in a New World" (Penguin, 2007).

Robert Graves defined hell as "words repeated endlessly until they all but lose their meaning." "Liquidity" is one such word from the financial lexicon. Yet, properly defined, it is the clue to the potentially disastrous outlook for the global economy and financial markets.

It is a no-brainer to say that the credit crunch is making liquidity scarce. It is less clear why central banks are powerless to do anything to stop it contracting, and why this shrinkage will sabotage economic growth as economies fall prey to the credit drought in places as far-flung as the Baltic states to China, as well in the OECD countries.

But to back up for a minute, what is liquidity? Two years ago, when confronted with financial-sector balance sheets and asset prices that were growing at a multiple of GDP and money supply that wasn't, we at Independent Strategy found our answer. At the time, there was precious little correlation between money and financial-asset prices. That seemed strange. Unless return on assets, measured by corporate return on capital, was rising exponentially, there was no justification for asset prices to be doing so.

Further research indicated that what was driving asset prices was the supply of copious and cheap credit with which to buy them. This type of asset money or credit was not counted in the traditional definition of liquidity, which is simply broad money, made up of central-bank money and bank lending.

The reason for the exponential growth in credit, but not in broad money, was simply that banks didn't keep their loans on their books any more -- and only loans on bank balance sheets get counted as money. Now, as soon as banks made a loan, they "securitized" it and moved it off their balance sheet.

There were two ways of doing this. One was to sell the securitized loan as a bond. The other was "synthetic" securitization: for example, using derivatives to get rid of the default risk (with credit default swaps) and lock in the interest rate due on the loan (with interest-rate swaps). Both forms of securitization meant that the lending bank was free to make new loans without using up any of its lending capacity once its existing loans had been "securitized."

So, to redefine liquidity under what I call New Monetarism, one must add, to the traditional definition of broad money, all the credit being created and moved off banks' balance sheets and onto the balance sheets of nonbank financial intermediaries. This new form of liquidity changed the very nature of the credit beast. What now determined credit growth was risk appetite: the readiness of companies and individuals to run their businesses with higher levels of debt.

No longer could central banks determine how much debt was created. They used to do that by limiting the amount of central-bank money they supplied, which formed the base of all loans, and then obliging commercial banks to make reserves for every loan. This made lending capacity finite. Now that the loans didn't stay on banks' balance sheets, this control mechanism was ineffective. Lending capacity became almost infinite -- for a while. Indeed, central banks didn't even control the price of money very well any more; again; risk appetite set how risk was priced and central-bank rates held very little sway over the outcome. Yield curves, which were inverting at the time, had the effect that when central banks raised rates, long-term credit markets reduced them.

The credit tide is now ebbing. Since August, the credit system has been frozen solid. Debt issuance for all sectors of the economy has plummeted. Banks don't trust each other's balance sheets (and they alone know how bad their assets are). The rates at which they lend to each other show the same levels of risk premium as at the outbreak of the crisis, despite central banks' efforts to inject liquidity into markets.

For these reasons the Federal Reserve this week announced joint actions with central banks around the world to ease liquidity conditions. The Fed said it will initiate a series of auctions under the Term Auction Facility (TAF) that will inject funds to a broader range of participant depositary institutions against a broader range of collateral. The minimum rate of interest charged will be the expected fed-funds rate over the term of the loan. The auctions start on Dec. 17 for an amount of $20 billion to be lent for 20 days. Other auctions are planned for Dec. 20, Jan. 14 and Jan. 28. At the same time, the Fed set up bilateral swap agreements with the Swiss National Bank and the European Central Bank, so that these central banks could also borrow U.S. currency to fund dollar liquidity needs among their own banks.

These measures are an extension of what central banks were doing anyway: substituting central-bank money for funds normally lent and borrowed between banks in the interbank market. The funds themselves are not a "net" addition to liquidity, because they are paid back when the loan becomes due. The Fed's additional TAF auctions will help fulfill the responsibility of the central bank to ensure the proper functioning of financial markets by providing temporary liquidity. But they are not an additional easing of monetary policy or a bailout of banks' bad assets.

Therein lies the problem: The auctions address a liquidity shortage -- caused by the banks' refusal to lend and borrow from each other due to mistrust of each other's balance sheets -- but cannot address the solvency problem inherent in the balance sheets themselves.

Moreover, much of the leverage that fuels the economy is downstream from the banks, and on the balance sheets of nonbank financial intermediaries (such as brokers, hedge funds and investment banks) in the form of securitized debt and derivatives. Neither these entities nor many of the assets they own are eligible for central bank loans.

It was excessively optimistic risk appetite and consequent mispricing of risk that created this leverage problem. The reversal of risk appetite is now driving the deleveraging process. Just as the central banks were powerless to control the expansion of liquidity in the expansionary phase, it is unlikely that they can control its contraction and its economic consequences.

The deleveraging process will be ugly. First, the junk assets that the banks moved off balance sheet will have to be financed by the banks, and a lot of them will have to be moved back onto banks' balance sheets. As this happens, bank lending capacity gets used up. Second, re-intermediated junk assets will have to be written down. This destroys bank capital and further reduces lending capacity.

Finally, future bank lending practice is going to be changed. Much more lending will be kept on banks' balance sheets. When loans are securitized, banks will remain responsible for the quality of the credit and have to make prudent reserves against it. All this means lower liquidity expansion, particularly of asset money, and lower economic growth.

In a globalized system, no one is immune. The big shock of 2008 will be that the China bubble pops. After all, where would China be without excessive global liquidity flooding into its domestic markets over a quasi-fixed exchange rate and excessive household borrowing stoking U.S. consumer demand for China's goods? We are about to find out.

Mr. Roche, president of Independent Strategy, a global investment consultancy based in London, is the author of "New Monetarism" (Independent Strategy, 2007).

Money IllusionsDecember 17, 2007; Page A20Groucho Marx once asked, "Who are you going to believe, me or your own eyes?" Too bad Groucho doesn't work at either the Federal Reserve or on Wall Street, where economists have been predicting that slower economic growth would lead to a slowdown in inflation. They should have believed their own eyes.

As any American who has shopped for groceries or gasoline can tell you, prices are rising. That was confirmed last Friday in the official figures for November, with overall consumer prices jumping 0.8% from a month earlier. That was the largest monthly gain in two years, and 4.3% higher than a year ago. The report for producer prices was equally as alarming a day earlier, rising 3.2%. The producer price index is up 7.7% in the past 12 months, on a seasonally adjusted basis.

Some analysts continue to ignore all this and focus on so-called "core" inflation, which excludes food and energy. That is cold comfort to Americans who devote increasingly larger chunks of their monthly budget to -- food and energy. One lesson of the past few years is that relying too much on core inflation data, as the Fed has done until recently, can be a dangerous mistake. We couldn't help but notice that former Fed Chairman Alan Greenspan, a longtime "core" watcher, was quoted last week as saying it is now a less reliable guide to monetary policy.

Not surprisingly, equity markets fell Friday on the inflation news -- the same markets that only a week earlier had been begging for easier money from the Fed. Anyone who recalls the 1970s understands that inflation is very bad for stocks in general, though of course price-sensitive shares like commodities can do very well for a while. If nothing else, the inflation figures should remind us that there is no free lunch for Wall Street in continuing its cheerleading for easier money.

It should also remind us once again that inflation doesn't rise or fall along with economic growth. Inflation is a monetary phenomenon and reflects the supply and demand for currency created by central banks. We learned in the 1970s that rising prices can co-exist with slower growth, and we learned in the 1980s, or should have, that rapid growth can co-exist with falling levels of inflation.

Those are lessons too many people seem to have forgotten this decade, which is why the Fed now has both less credibility and less leeway to ease money amid the housing recession and mortgage mess. If politicians want to help the economy, they'll stop relying on the monetary delusion and instead focus on fiscal policy -- specifically, a tax cut.

Global stock markets are down in large part because the world is concerned that the US economy is in a recession and our politicians and policymakers are clueless in the face of this predicament. The Bush administration and the presidential hopefuls are all talking about fiscal stimulus plans that mostly involve taking money from one person's pocket and putting it in another (e.g., tax rebates). You can't make an economy stronger by funding one man's extra spending with money taken by taxing or borrowing from another man. Policies oriented to increasing consumer demand have no ability to expand the economy, otherwise (as Jude Wanniski used to say) we could spend ourselves to prosperity. Meaningful stimulus has to involve a permanent change in the incentives to work and invest, since that expands the output/supply side of the economy; ultimately, only rising incomes can fuel rising spending. In the below article Richard Rahn talks about a simple fix to the tax code which could make a world of difference: indexing capital gains for inflation. What politician, even the die-hard Democrats who hate it that the rich are getting richer, would want to argue in an election year against tax reform that is fundamentally fair, would help everyone, and would boost the economy? Word is that the Bush administration is considering precisely this as part of a fiscal stimulus package. The idea first cropped up in the early 1990s, but was abandoned. Now would be a great time to revive it. With all the pessimism out there it's about time somebody did something positive.

This is especially timely because with the Fed's latest effort to boost the economy by lowering interest rates, inflation risk is rising. We've already seen inflation rise from a low of 1% in 2003 to 3-4% currently, thanks to Alan Greenspan's misguided decision to push interest rates down to 1% in 2003. That not only contributed to the housing price bubble, but also drove the dollar down and boosted commodity and gold prices. Since it became obvious last summer that the Fed would be forced to lower rates to stem the losses from subprime lending, the dollar is down over 5% and is now at an all-time low, and gold is up 35% to almost $900/oz. Lower interest rates may help fix the subprime crisis by slowing and limiting the decline in home prices, but only at the cost of higher inflation in the years to come. Without this inflation-adjustment fix, the effective rate on capital gains will be rising significantly, and that would place a big burden on the stock market and the economy. Let's keep our fingers crossed that someone back in Washington can figure this out before it's too late.

Rudy Giuliani's tax-reform proposal includes indexing capital-gains taxes for inflation -- that is, putting the original price of the asset in today's dollars. All of the Republican candidates have called for low or lower taxes on capital gains, while the Democrats favor higher capital-gains taxes. But inflation-indexing of capital gains should be part of every candidate's "economic stimulus" package, regardless of party affiliation.

Accounting for inflation in this way has the advantages of producing more short-term revenue to the Treasury as long-term gains are "unlocked." Furthermore, lowering the cost of capital would stimulate investment and the stock markets, and would increase the fairness of the tax system by not taxing phantom gains for people at all income levels. It would also square capital-gains taxation with the U.S. Constitution.

Assume you purchased a common stock in a company in 1984 for $100 a share and sold it in 2007 for $200 a share. Have you received any "income" from the sale of the shares of stock? The IRS would say "yes," but this is clearly wrong. The IRS will claim that you had a $100 per share capital gain on the stock in the above example, yet actually the increase was solely a result of inflation. Because you cannot buy more goods and services with $200 now than you could have with $100 in 1984, you have had no "income" or wealth accretion.

Over the years numerous economists, lawyers and others have tried to fix this problem and have gotten nowhere with Congress. But now, due to increased concerns about inflation, economic growth and judicial salaries, the time may be right to move forward.

Chief Justice John Roberts has just renewed his call for an increase in pay for federal judges. He, his predecessor William Rehnquist and other judges have complained about the "steady erosion" of judicial salaries over the past 20 years. According to Article III, Section I of the U.S. Constitution, compensation of federal judges "shall not be diminished during their Continuance in Office."

As inflation has outstripped the increase in judicial salaries, the judges have clearly had "diminished compensation" in real terms. Chief Justice Roberts currently makes $212,000 per year, yet all but five of his predecessors in the past 200 years made more in inflation-adjusted dollars (Warren Burger's 1969-1986 income averaged about $250,000 per year in 2006 dollars).

The debate centers on the definition of income. The 16th Amendment to the Constitution states, "The Congress shall have the power to lay and collect taxes on incomes," and the Fifth Amendment clearly states, "No person shall . . . be deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use without just compensation."

If the portion of a capital gain due solely to inflation is not income, then taxation without inflation-indexing is an unconstitutional taking of property. Income is commonly defined as, "the amount of money or its equivalent received during a period of time in exchange for labor or services from the sale of goods or property, or as profit from financial investments."

To be money or its equivalent, the payment must have the power to command goods or services produced in the economy. Thus, if the money received from the sale of an asset cannot command more goods and services than the original capital invested, there clearly has been no income.

Too few judges and members of Congress have a basic understanding of economics. As a result, they do not readily see how small but steady losses in value over long periods (except when it comes to their own salaries) is damaging. Inflation of 2%, 3% or 4% per year may seem trivial, but over time it causes great distortions -- the U.S. dollar is now worth less than 1/20th of what it was worth in 1913 when the Fed was established. If the 12% inflation the U.S. experienced in 1979 had continued, the price level would have doubled every six years.

Congress, in order to prevent unlegislated tax-rate increases, has indexed the tax brackets and some other parts of the income-tax code for inflation, which recognizes that a dollar of income in 1998 is not the same as one in 2008. Yet they have failed to do this for capital gains or the AMT, which is now creating great heartache for them as well as for taxpayers. For the code to be logically consistent and to avoid an unconstitutional taking of property -- and for the word "income" to have the same meaning throughout the code -- any capital gain necessarily needs to be indexed for inflation.

The reasons capital gains have not been indexed for inflation (in addition to some members of Congress and judges who do not understand the proper definition of income) are that some argue it would be too complex, and that, since capital gains are taxed at a lower rate than regular income, the problem has already been addressed. Some claim it would result in a big revenue loss. But in the age of advanced tax software, indexing of capital gains is no more complex than many other provisions of the tax code. (The whole code needs to be simplified, but that is another issue.)

Taxing capital gains at a lower rate is done for a number of good economic reasons, and only offsets inflation for assets that have appreciated rapidly in a short time period. Adjusting capital gains for inflation would clearly increase revenues in the short run because of the "unlocking" effect, and probably over the long run because of the higher levels of investment it would stimulate. Over the past 30 years, the Joint Tax Committee, using largely static models, has consistently erred grossly -- at times even getting the direction of the plus or minus sign wrong -- in forecasting capital-gains tax revenues as a result of tax-rate changes.

The Bush administration ought to make inflation indexing part of its "stimulus package." If properly explained, considerable bipartisan congressional and judicial support should be obtained. A number of legal scholars have argued that the executive branch could unilaterally make the change by requiring the IRS to correctly define the words "cost" and "income," given that it was the IRS that originally incorrectly defined them.

It is not likely that many judges or members of Congress would find it in their personal, political, or the national interest to argue that phantom gains are "income." After all, most Americans do understand the meaning of income, even if some in Washington do not.

Mr. Rahn is the chairman of the Institute for Global Economic Growth and an adjunct scholar at the Cato Institute.

There is something ironic about having Congress -- which is holding hearings on steroid use in baseball -- trying to solve our current economic challenges with the economic equivalent of fiscal steroids.

The maneuvering and posturing in Washington has assumed all of its normal pre-failure patterns.

The fact is, there could be no greater contrast between the approach I outlined in my new book, Real Change, and the traditional insider politics of Washington.

A Washington Insider Economic Package That Is Too Small and Too Temporary

Republican staff advisers are developing an economic package within the timid boundaries allowed by the Washington establishment. The package they are working on is too small, too temporary and clearly inadequate for the scale of the economic problems we face.

To make matters worse, the Democrats who control Congress will begin demanding even less-useful and more-destructive economic proposals that will spend a lot more money with even less hope of helping the economy.

The Federal Reserve chairman will forget that his primary job is protecting the stability and strength of the dollar and will become a complicit political player in trying to develop an insider package that will only weaken the dollar still further. We saw evidence of this yesterday, when Chairman Bernanke and his colleagues reduced the Federal Reserve's federal funds rate three-quarters of a percentage point. As a result, the dollar dropped in global markets almost immediately.

In short, the normal patterns of Washington, D.C., are likely to lead to temporary, marginal tinkering when what America really needs is long-term, fundamental reform to protect the dollar, increase productivity and create jobs.

A Familiar Pattern of Failure

We are witnessing the same destructive pattern that led to "stagflation" in the 1970s -- the economic disaster that ultimately led Gov. Ronald Reagan to win the presidency on the dual pledges of anti-inflationary monetary policy and a fiscal policy of cuts in non-defense spending, regulation and taxes in order to revive the economy.

This same destructive pattern led the first Bush Administration to break its "no new taxes pledge," which set the stage for the Democratic victory of 1992.

And it was this same pattern that led the Clinton Administration to adopt the largest tax increase in history in 1993 and set the stage for the Contract with America and the first Republican House majority in 40 years.

This pattern of Washington insider negotiating and posturing is doomed to fail politically because of the power of the world financial news system and because this gimmicky approach goes against the fundamental desires of the American people.

Just open the financial pages from yesterday: The world markets have already condemned the initial administration proposals.

If the stimulus package was designed to be a confidence builder, it is clearly failing.

On Monday, London fell 5.48%, Germany 7.16%, China 5.14%, Hong Kong 5.49% and India 7.41%. This was the world's investors' way of making clear they were not reassured.

Furthermore, to make the situation even more intense, the power of the markets is amplified by the global financial news system. Market reactions are transmitted instantly, 24 hours a day, by cable news and other news outlets.

I was on the new Fox Business Channel as a guest on Neil Cavuto's show Monday evening (read a transcript here). By then, it was clear that the on-air analysts were joining the investors in condemning the stimulus package as inadequate and ineffective.

Americans Want Long-Term Solutions

The American people will ultimately reject the stimulus package, because it violates one of their deepest beliefs. Americans believe in long-term solutions, not short-term fixes. This Washington insider maneuvering is politics as usual at a time when the American people are crying out for a change of course.

In our American Solutions polling last summer, the American people told us by a margin of 92% to 5% that our goal should be to provide long-term solutions instead of short-term fixes. You can find this and other economic data in the Platform of the American People in Real Change and at AmericanSolutions.com.

Overwhelmingly, the American people told us that they are prepared to be told the truth and for large, fundamental changes.

Short-term fixes are going to be rejected by the American people, and the politicians who endorse them are going to find their reputations suffering as a result.

Why a Washington Insider Stimulus Package Will Fail Economically

The stimulus packages being discussed won't just fail politically, they'll also fail economically. The size of the challenge is much bigger than the size of the current solutions being offered by Washington.

Consider these economic indicators:

Gold has been hitting record highs ($914.30 an ounce a week ago). Gold was up 32% in 2007.

U.S. Treasury notes, historically the best store of currency value, have lost 20% compared to gold since August 2007.

Silver has hit a 24-year high ($16.60 an ounce last week).

Platinum has skyrocketed to $1,592 an ounce (and if platinum is a primary metal in the next generation of cars, the world's supply will run out in 15 years, according to some estimates).

The declining dollar has been a similar indicator of inflationary pressures coming.

The producer price index was up 7.7% through November 2007. That is the biggest jump in 34 years.

The consumer price index was up 4.2% through November 2007. That is the biggest jump in 17 years.

The Role of the Federal Reserve: To Protect the Value of the Dollar

In this setting, it is important for Chairman Ben Bernanke and the Fed to remember their primary mission: protecting the value of the dollar.

People want their government to keep the value of its currency. We won't save and invest if we think politicians are going to steal our earnings and savings by inflating the currency.

The Fed should focus its eye firmly on strengthening the dollar and driving inflation down to 2%.

If the world came to believe the Fed was serious about protecting the dollar, the price of oil would decline substantially, the price of gold would decline substantially, the world's capital flows would return to the United States and the economy would be inherently healthier.

Creating Jobs and Productivity While Stabilizing the Dollar

If the Federal Reserve should focus on creating a stable dollar, the President and Congress should focus on increasing productivity and creating jobs.

Our political leaders should concentrate on making the American worker more successful in competing with China, India, Japan and Europe. They should also ensure that long-term productivity gains in the United States result in real prosperity that would enable Americans to pay off their debts and increase their savings for their retirement years.

Recognizing the Reality of Democratic Control of Congress

Any economic plan has to start with the recognition that Democrats control Congress. That means they get to have a large say in a successful package.

The difficulty here is compounded by the fact that the Democrats have a lot less to lose by allowing nothing to happen, because they will blame any economic problems on President Bush and the Republicans.

The key is to give the Democrats substantial influence over half the economic growth package -- the half aimed at increasing consumer spending -- but insist that the President and Republicans control the other half of the package aimed at increasing productivity and creating jobs.

Give Democrats Control Over Half the Stimulus Package. . .

If Republicans were proposing consumer stimulus plans, an ideal change would be to offset the payroll tax for both individuals and employers. Almost nothing would increase take-home pay for working Americans as fast or enable businesses to hire more people.

A second good option would be a significant increase in the tax allowance for children. This would help working families and single working mothers and could have a very positive impact.

For their part, the Democrats will almost certainly want some kind of direct giveaway program of rebates or some other payment.

As long as the amount is capped at half of a very robust package (say $150 billion of a $300 billion package), it should be the price Republicans pay to get a productivity-increasing bill through a Democratic Congress.

Here's the bottom line trade-off: Republicans should offer relative freedom to the Democrats to design the consumer stimulus part of the bill but then insist on similar freedom to design the productivity increasing portions of the bill.

. . .With a Big 'If'

There is a big "if" involved in this approach.

The Republicans have to be prepared to play hardball. They have to stand firm for a powerful productivity- and growth-oriented component or be prepared to accept the failure of the package.

The Democrats will attempt to panic the Republicans into giving up all their principles just to get "something" passed quickly.

It is very important for the President and House and Senate Republicans to stand firm for a sophisticated package that would actually increase productivity.

The first key to productivity improvements is that they have to be permanent so people can rely on them.

A Bold Plan for Economic Growth

What America needs is deep, fundamental reform to make American businesses more competitive so American workers have better paying jobs with greater job security.

The change from the current situation to a powerfully competitive American future is a much bigger change than anyone in Washington is contemplating.

Here are a few proposals that would begin to move us in the right direction:

1. Adopt the Rangel proposal for a corporate income tax cut.

When even liberal Democrats such as Ways and Means Chairman Charlie Rangel (D-N.Y.) recognize that the United States is killing jobs at home by having the second-highest corporate income tax in the world, there is a possibility of getting something done. In Rangel's generally bad bill of massive tax increases there is a provision for a corporate income tax rate cut. Republicans should simply lift that section from his bill and propose it in his name.

2. Abolish or index the capital gains tax.

A plurality of Americans favor abolishing the capital gains tax (American Solutions polling found a margin of 49% to 41%). This number will go up as Americans look at the disastrous impact of the financial meltdown on their planned retirement funds and their children's college education funds.

Abolishing the capital gains tax would lead to an immediate jump in the value of the stock market, leading to an immediate jump in the value of every retiree's 401(k). More importantly, it would lead to a burst of new investments in the United States, creating a foundation for long-term economic growth.

If abolishing capital gains is politically impossible for Democrats (who tend to be anti-capital in between high-dollar fundraisers) to accept, then the fallback position should be to index the capital gains tax so inflation does not erode capital gains. As Richard Rahn has pointed out, this would have a big effect on increasing investment in America.

3. Allow 100% expensing of all investments in new equipment.

If American businesses could write off 100% of their new equipment within one year of its purchase, there would be a boom in equipping American workers with the best and most modern equipment so they can compete with any economy in the world.

These kinds of real, permanent changes would begin to make America more competitive and more productive. They will allow the dollar to increase in value as investors start to buy up dollars to invest in the low-tax U.S. economy. In turn, this will give the Fed more room to keep interest rates low. These changes would be a step toward permanent, long-term, improved economic health.

And Don't Forget About Scoring

It is essential to remember that anything good for the American economy will be scored badly by the bureaucrats at the Joint Tax Committee and the Office of Management and Budget. Both bureaucracies have a history of being anti-capitalist, anti-market and anti-growth in predicting how economic policy changes will effect economic growth and government revenue.

The answer, however, is simple.

Establish a margin of error equal to how wrong they were in scoring revenue from the last cycle of tax cuts. Then declare that anything within that margin of error is scored as acceptable.

The fact is that it is impossible to establish sound policy for economic growth with Socialist scoring. However, in the short run, it is impossible to change these two entrenched bureaucracies.

Therefore, the answer is simply to publish the degree to which the bureaucrats were wrong in the last two or three tax-cutting cycles and write the bill within that margin of historically provable inaccuracy.

In the Platform of the American People, there is overwhelming support for an optional flat tax with a one page tax form. South Carolina Gov. Mark Sanford (R) has picked up on this overwhelming desire for real change in how we pay taxes.

Here's what Gov. Sanford had to say about the optional flat tax in his State of the State address:

"A flat tax alternative that would allow someone the option of forgoing exemptions and instead pay a 3.4% flat tax in this state. We continue to believe finding ways to lower the marginal tax rate is vital to our economy, vital to competitiveness and in this case vital to the taxpayer's pocket. It is worth noting that a recent report from the Federal Reserve documented the connection between lower income tax rates and higher economic and employment growth. This is something we can do to better the economy of our state, and I'd thank Rep. Merrill for introducing a bill toward this end."

Louisiana's Jindal Starts With Accountability and Transparency

Newly elected Louisiana Gov. Bobby Jindal (R), one of the brightest and most creative people in public life, began his governorship with an executive order making state spending transparent and ordering it to be posted on the Internet so every citizen could see how their tax money is being spent.

For a Louisiana governor, this was an enormous step toward reform.

Transparency in government spending is a growing movement among the states and, like so much of the innovation on the state level in America, it's an idea the President would do well to make his own.

Publishing all non-classified federal spending on the Internet would put the power to unearth fraud and abuse in the hands of the American people.

It would be a step toward real accountability in government.

In other words, it would be real change, just what we need in Washington right now.

A Global FedJanuary 26, 2008; Page A10This week the world learned that economic "decoupling" from America is a myth. The next lesson to re-learn is that the Federal Reserve's monetary mistakes have global consequences, and that one result of the Fed's great dollar miscalculation this decade has been a dangerous breakdown in world monetary cooperation.

Look no further than the European Central Bank, which was notably absent when the Fed made its emergency rate cut amid falling global stocks on Tuesday. In testimony Wednesday before the European Parliament, ECB President Jean-Claude Trichet came about as close as a member of the brotherhood ever will to calling out a fellow central banker: "In demanding times of significant market correction and turbulences, it is the responsibility of the central bank to solidly anchor inflation expectations to avoid additional volatility in already highly volatile markets."

If we can interpret Mr. Trichet further, he thinks the Fed helped to create the current financial mess by going on a bender in the late Alan Greenspan era, and is now once again running dangerous inflation risks by cutting rates too soon in the face of Wall Street pressure. He's also unhappy because the dollar's fall against the euro has increased political pressure on the ECB to ease as well. So now that the Fed wants his help to avoid a further dollar decline against the euro, he's in no mood to oblige.

Mr. Trichet has a point about American mistakes, and for that matter so do all the Davos-types chortling this week about U.S. credit woes. Europeans and many Asians love to see the Yanks humbled, and the sight of America's banking giants going hat in hand to Abu Dhabi, Singapore and China is too much Schadenfreude to pass up. One irony is that the cause of all this Yankee humiliation isn't the familiar Euro-gripe about the "trade deficit" or tax cuts. It is monetary policy. But they'll enjoy it whatever the cause.

They shouldn't get carried away, however, because their own stock markets were showing earlier this week what could happen to European and Asian economies if the U.S. heads into recession. The $7 billion fraud at Société Générale and the mess at Britain's Northern Rock mortgage lender also make clear that American bankers don't have a monopoly on bad judgment. The currency reserves and sovereign wealth funds that many countries have been piling up are in substantial part the result of that same Fed mistake. This means they can vanish as fast as they arose if commodity prices fall again and the dollar rises. Recall the Texas oil patch, circa 1983, as Paul Volcker's Fed corrected the inflation of the 1970s.

Mr. Trichet also has an advantage over Fed chairman Ben Bernanke in that his mandate under the ECB constitution is to focus solely on the price level. Under Humphrey-Hawkins, the Fed must target the price level and employment. Mr. Trichet is right to keep his own eye on a stable euro, but we also wish he and the Fed weren't so obvious about their mutual discord.

The other great casualty of the Fed's blunder has been the global dollar bloc. This had been building for years, as more nations adopted either formal (such as a currency board) or informal dollar links to their currencies. A stable exchange rate creates economic and trading efficiencies, while a formal dollar link means a country can reduce political uncertainty by delegating its own monetary policies to the Fed.

This made sense as long as the dollar's value was stable. But as the dollar has fallen, these countries have imported inflation and some are now severing their dollar links. The Gulf Cooperation Council is mulling a link to a euro-dominated basket of currencies, and even China is slowly revaluing the yuan against the dollar -- less because of U.S. political pressure than out of its own self-interest to control internal inflation.

This world of greater exchange-rate volatility is dangerous. The extreme movements of the euro versus the dollar across the last decade have created enormous uncertainty for business, while distorting trade and investment flows. They also contribute to economic anxiety and a populist trade backlash. The collapse of the dollar bloc, if it continues, will add to this exchange-rate volatility and in the worst case make it easier for beggar-thy-neighbor currency manipulation.

This week showed once again that the world needs more monetary cooperation, not less. As the world's most important central bank, the Fed must take the lead. And the way to start is by sending a message that its monetary decisions will be based on a renewed determination to protect the value of the dollar and its role as a reserve currency.

It is hard to imagine any time in history when such rampant pessimism about the economy has existed with so little evidence of serious trouble.

True, retail sales fell 0.4% in December and fourth-quarter real GDP probably grew at only a 1.5% annual rate. It is also true that in the past six months manufacturing production has been flat, new orders for durable goods have fallen at a 0.8% annual rate, and unemployment blipped up to 5%. Soft data for sure, but nowhere near the end of the world.

It is most likely that this recent weakness is a payback for previous strength. Real GDP surged at a 4.9% annual rate in the third quarter, while retail sales jumped 1.1% in November. A one-month drop in retail sales is not unusual. In each of the past five years, retail sales have reported at least three negative months. These declines are part of the normal volatility of the data, caused by wild swings in oil prices, seasonal adjustments, or weather. Over-reacting is a mistake.

A year ago, most economic data looked much worse than they do today. Industrial production fell 1.1% during the six months ending February 2007, while new orders for durable goods fell 3.9% at an annual rate during the six months ending in November 2006. Real GDP grew just 0.6% in the first quarter of 2007 and retail sales fell in January and again in April. But the economy came back and roared in the middle of the year -- real GDP expanded 4.4% at an annual rate between April and September.

With housing so weak, the recent softness in production and durable goods orders is understandable. But housing is now a small share of GDP (4.5%). And it has fallen so much already that it is highly unlikely to drive the economy into recession all by itself. Exports are 12% of the economy, and are growing at a 13.6% rate. The boom in exports is overwhelming the loss from housing.

Personal income is up 6.1% during the year ending in November, while small-business income accelerated in October and November, during the height of the credit crisis. In fact, after subtracting income taxes, rent, mortgages, car leases and loans, debt service on credit cards and property taxes, incomes rose 3.9% faster than inflation in the year through September. Commercial paper issuance is rising again, as are mortgage applications.

Some large companies outside of finance and home building are reporting lower profits, but the over-reaction to very spotty negative news is astounding. For example, Intel's earnings disappointed, creating a great deal of fear about technology. Lost in the pessimism is the fact that 20 out of 24 S&P 500 technology companies that have reported earnings so far have beaten Wall Street estimates.

Models based on recent monetary and tax policy suggest real GDP will grow at a 3% to 3.5% rate in 2008, while the probability of recession this year is 10%. This was true before recent rate cuts and stimulus packages. Now that the Fed has cut interest rates by 175 basis points, the odds of a huge surge in growth later in 2008 have grown. The biggest threat to the economy is still inflation, not recession.

Yet many believe that a recession has already begun because credit markets have seized up. This pessimistic view argues that losses from the subprime arena are the tip of the iceberg. An economic downturn, combined with a weakened financial system, will result in a perfect storm for the multi-trillion dollar derivatives market. It is feared that cascading problems with inter-connected counterparty risk, swaps and excessive leverage will cause the entire "house of cards," otherwise known as the U.S. financial system, to collapse. At a minimum, they fear credit will contract, causing a major economic slowdown.

For many, this catastrophic outlook brings back memories of the Great Depression, when bank failures begot more bank failures, money was scarce, credit was impossible to obtain, and economic problems spread like wildfire.

This outlook is both perplexing and worrisome. Perplexing, because it is hard to see how a campfire of a problem can spread to burn down the entire forest. What Federal Reserve Chairman Ben Bernanke recently estimated as a $100 billion loss on subprime loans would represent only 0.1% of the $100 trillion in combined assets of all U.S. households and U.S. non-farm, non-financial corporations. Even if losses ballooned to $300 billion, it would represent less than 0.3% of total U.S. assets.

Beneath every dollar of counterparty risk, and every swap, derivative, or leveraged loan, is a real economic asset. The only way credit troubles could spread to take down the entire system is if the economy completely fell apart. And that only happens when government policy goes wildly off track.

In the Great Depression, the Federal Reserve allowed the money supply to collapse by 25%, which caused a dangerous deflation. In turn, this deflation caused massive bank failures. The Smoot-Hawley Tariff Act of 1930, Herbert Hoover's tax hike passed in 1932, and then FDR's alphabet soup of new agencies, regulations and anticapitalist government activity provided the coup de grace. No wonder thousands of banks failed and unemployment ballooned to 20%.

But in the U.S. today, the Federal Reserve is extremely accommodative. Not only is the federal funds rate well below the trend in nominal GDP growth, but real interest rates are low and getting lower. In addition, gold prices have almost quadrupled during the past six years, while the consumer price index rose more than 4% last year.

These monetary conditions are not conducive to a collapse of credit markets and financial institutions. Any financial institution that goes under does so because of its own mistakes, not because money was too tight. Trade protectionism has not become a reality, and while tax hikes have been proposed, Congress has been unable to push one through.

Which brings up an interesting thought: If the U.S. financial system is really as fragile as many people say, why should we go to such lengths to save it? If a $100 billion, or even $300 billion, loss in the subprime loan world can cause the entire system to collapse, maybe we should be working hard to build a better system that is stronger and more reliable.

Pumping massive amounts of liquidity into the economy and pumping up government spending by giving money away through rebates may create more problems than it helps to solve. Kicking the can down the road is not a positive policy.

The irony is almost too much to take. Yesterday everyone was worried about excessive consumer spending, a lack of saving, exploding debt levels, and federal budget deficits. Today, our government is doing just about everything in its power to help consumers borrow more at low rates, while it is running up the budget deficit to get people to spend more. This is the tyranny of the urgent in an election year and it's the development that investors should really worry about. It reads just like the 1970s.

The good news is that the U.S. financial system is not as fragile as many pundits suggest. Nor is the economy showing anything other than normal signs of stress. Assuming a 1.5% annualized growth rate in the fourth quarter, real GDP will have grown by 2.8% in the year ending in December 2007 and 3.2% in the second half during the height of the so-called credit crunch. Initial unemployment claims, a very consistent canary in the coal mine for recessions, are nowhere near a level of concern.

Because all debt rests on a foundation of real economic activity, and the real economy is still resilient, the current red alert about a crashing house of cards looks like another false alarm. Warren Buffett, Wilbur Ross and Bank of America are buying, and there is still $1.1 trillion in corporate cash on the books. The bench of potential buyers on the sidelines is deep and strong. Dow 15,000 looks much more likely than Dow 10,000. Keep the faith and stay invested. It's a wonderful buying opportunity.

Republicans may be on the verge of selecting a nominee, but Democrats are making plans for some long trench warfare.

Mark Penn, a pollster and key strategist for Hillary Clinton, told reporters on a conference call yesterday that he thinks "the search for delegates is going to continue... straight through to the convention."

Mr. Penn also told reporters that while Barack Obama has been basking in his endorsement by Ted Kennedy, there are signs that voters are starting to see Mr. Obama as just another politician: "I think there's a growing perception that Sen. Obama is on the attack."

Logistics also favor the Clinton campaign in the Super Tuesday primaries to be held next week. Mr. Penn noted that unions with six million members are backing the New York Senator and will be on the ground providing get-out-the-vote muscle and resources to deliver her supporters to the polls.

-- John FundMitt Closes His Wallet

Nothing in yesterday's GOP presidential debate from the Reagan Library in California changed John McCain's front-runner status. Mr. McCain was clearly not particularly likeable or at the top of his game but he swatted away the criticisms hurled at him with ease. Mitt Romney was dragged into a lengthy defense on an alleged statement he made about a timetable for withdrawal in Iraq. As the old adage goes: if you are explaining, you are not gaining.

Mr. Romney has only a few days left to change the dynamic of the race before 21 states vote next Tuesday. As of yesterday afternoon, his campaign had purchased no television ad time in any of the Super Tuesday states. "If Thursday goes by without an ad buy, it will be a sign the Romney campaign is only going through the motions," says one TV advertising expert with ties to no candidate. "After all, we know he can write a check if he has to."

-- John FundThe Candidate Who Memorized 'In Search of Excellence'

At last night's (blessedly) final Republican presidential debate, Mitt Romney had the look, and sound, of someone who knows it's over. While predictions in this political season have become a fool's game, I am going to venture that no matter how many states he competes in, Gov. Romney knows he will never close the five-point gap that separated him from John McCain in New Hampshire and now Florida.

Last night the famous Matinee Mitt smile of self-confidence seemed to have been replaced by a more relaxed, wistful glance over at the Arizona Senator seated next to him. That resigned, tight smile said something: I am smarter than you are, Senator, on virtually every issue other than who ran Pakistan 10 years ago, but I am still losing. Why?

Here's why. As was clear again in last night's debate, Gov. Romney's message on the campaign trail or on TV was a perpetual data-dump. Yes, Mitt was smarter than the other guys, but he had the smartest-kid-in-the-class malady of compulsively trying to show off his brain with what in the end merely amounted to a lot of policy details, a lot of "stuff." Did anyone ever understand his explanation of his Massachusetts health care reform?

Result: His message was disorganized. The bumper sticker was "Let Mitt Fix Washington," but the Mitt fix itself came across to audiences as a grab-bag of analysis, nostrums and pieces of supporting data pulled randomly from some folder in his brain. As Mike Huckabee might put it, the bane of the Romney candidacy was Bain & Company. Bain is the consulting firm where by his own admission Mr. Romney learned how to think about the world -- through the eyes of a management consultant. As any CEO who has ever hired one of these firms will tell you, they are fascinating guys to talk to but you wouldn't want them actually running your company.

The Romney candidacy never quite came into focus. Yeah, fix Washington, but beyond that a blizzard of technocratic data at every whistlestop. One can see why he'd be maddened losing to the almost stolid McCain candidacy. But no one could miss the McCain message: national honor, a duty to fulfill the nation's responsibilities and the real and present danger of an external threat. It's a mindset they teach in the military but not in consulting: Keep it simple, stupid.

Mitt couldn't. He's done.

-- Daniel HenningerQuote of the Day

"One reality is likely to emerge for voters who care most about national security: John McCain enthusiastically supported the surge, the key course correction in a battle that all Republicans call the 'central front' in the war on terror -- and he did so at great political risk. Still, McCain had several moments [in last night's debate] that will anger conservatives. His line that he worked 'for patriotism, not for profit' is bad. Romney rightly suggested that small business owners will be offended at the implication that profits are somehow ignoble. McCain earns a lot of support because of his service -- military and political. But people know it without him touting his own patriotism. McCain threw a sharp elbow at Romney for laying people off during his time as a venture capitalist. It was unwise and undignified. I imagine his advisers all cringed at the substance and timing of it" -- Stephen Hayes, writing on last night's GOP debate at weeklystandard.com.

Class of '94

The recent retirement announcements by Reps. Tom Davis (R-Va.) and Dave Weldon (R-Fla.) means that 28 Republicans in the House of Representatives will not be returning in 2009, and scratches two more members of the historic 1994 Republican freshman class from the House roster. Out with the tide is slowly going the Republican commando force that, led by Newt Gingrich and campaigning on the "contract with America," ended 40 years of Democratic control in the House.

In 2006, eight members of the 1994 class were either defeated or resigned in scandal. And the attrition continues. Along with Mr. Davis and Mr. Weldon, fellow 1994 classmates Barbara Cubin (R-Wyo.), Ray LaHood (R-Ill.) and Jerry Weller (R-Ill.) are retiring this year. Among the five, only Mr. LaHood was not likely to be seriously challenged. With their retirements, plus the recent appointment of Rep. Roger Wicker (R-Miss.) to the Senate, the 73-member Republican Revolution class will have dwindled to 17 by next year.

The only remaining 1994 class member who is likely to face serious re-election competition this year is Rep. Walter Jones (R-N.C.), whose toughest race may be in the Republican primary. In 2007, Mr. Jones was one of only two Republicans to join Democrats in co-sponsoring the non-binding resolution opposing President Bush's troop surge in Iraq. The same congressman who in 2003 pushed the House cafeteria to rename French fries "freedom fries" is now facing a challenge from the right for his stance on the Iraq war.

The 'Stimulus' MarketsFebruary 6, 2008WSJPresident Bush and Congress are marching arm in arm to pass their economic "stimulus," but it's clear that at least one group of observers isn't impressed: investors. They blew right through all the Beltway happy talk yesterday, selling off the major stock indexes by some 3% or so on an ugly day.

Investors were more impressed, or we should say depressed, by the plunge in the Institute for Supply Management's services index for January. The ISM survey took a header to 41.9, down from 54.4 for December, which suggests a decline in the service economy for the first time in nearly five years. Any reading below 50 indicates contraction, so January's reading is another talking point for those who think the economy is heading toward recession.

Heretofore, the recession evidence had been decidedly mixed. Friday's Labor Department jobs report for January was rotten with a decline of 17,000, but a private sector survey that's typically accurate found 130,000 new jobs. Durable goods were strong last week, and the ISM manufacturing survey also showed surprising strength above recession levels. But with services now such a dominant part of the U.S. economy, there's no sugar-coating yesterday's report.

Naturally, the ISM news encouraged predictions that the Federal Reserve will have to cut interest rates even more than it has in the past two weeks. The Fed's Open Market Committee next meets on March 18, but given its recent willingness to respond to Wall Street's demands, look for more voices to encourage another big "emergency" interest rate cut before then.

In case the Fed still cares, however, we'd note that yesterday's ISM report was hardly reassuring on prices. The prices paid index came in at 70.7, down only slightly from December's 71.5, which suggests considerable upward pricing pressure. In the 1970s, the word for this kind of predicament was "stagflation."

And, much like the 1970s, the political class is riding to the fiscal rescue with a "jobs program" designed mostly to preserve its own jobs. The House passed its $146 billion version of tax rebates and tax credits last week, while the Senate wants to raise the bidding to $157 billion. Republicans tried to resist this last week, but yesterday the White House signaled it will roll over again. Treasury Secretary Hank Paulson said he'll "work something out" on expanding the tax rebates to include 20 million retirees.

These one-time federal checks will give Americans a little more ready cash in time for Election Day, but they aren't impressing investors worried about recession. Yesterday's selloff came despite the White House concession to the Senate, and perhaps even because of it. The real damage from this exercise in bipartisan self-delusion is the lost opportunity for a serious tax cut that would increase incentives for capital investment and risk-taking.

Meanwhile, Senator John Sununu (R., N.H.) is being attacked by Democrats for voting against the extra Senate "stimulus" last week. As one of the strongest pro-growth voices still left in the Senate, but facing a tough re-election battle, Mr. Sununu's prospects aren't helped by yesterday's White House retreat. Mark that down as another reason investors can be forgiven for looking at Washington, and then selling stocks.

When the United States broke up the Bretton Woods international monetary system on Aug. 15, 1971, it marked the official end of an era when the dollar was literally "as good as gold." President Nixon's announcement -- that the U.S. would no longer permit foreign central banks to redeem U.S. dollars for gold at the established fixed rate -- shocked Japan and Europe, our main overseas trade partners.

It was the repudiation of a formal agreement hammered out some 27 years earlier at Bretton Woods, N.H., and signed by delegates from 29 participating nations. The whole purpose of the agreement -- which was initiated by the U.S. -- was to establish a stable, post-World War II monetary foundation so that free trade could flourish. Never again would nations shortsightedly cheapen their currencies to obtain an unfair advantage; the nightmare of economic warfare leading to military warfare would be ended.

Today, our trade partners are no longer shocked. They have come to expect domestically focused monetary policy from America. But they are deeply concerned by the demise of the once-dependable dollar and deeply impacted by the economic distortions caused by skewed exchange rates. They are, no doubt, deeply affronted by what they detect as the same cavalier attitude that decades earlier prompted Nixon's Treasury Secretary, John Connally, to quip to U.S. allies: "It may be our currency -- but it's your problem."

Has the U.S. forever given up on the dream of a rules-based monetary order for a global economy dedicated to free trade? Have we abandoned all sense of duty associated with providing the world's key reserve currency?

These days it's easy to forget that, during the Great Depression years leading to World War II, floating exchange rates were not considered the free-market approach to currencies. They were considered the antithesis of global monetary order. Whereas the international gold standard guaranteed a level playing field in the trade arena, facilitating market-based outcomes among well-intentioned competitors in an open global marketplace, a nation that devalued its money against gold -- i.e., floated its currency -- was considered to be cheating.

Monetary manipulation was akin to moving the goalposts, an attempt to increase exports of your country's goods by rendering them less expensive when calculated in foreign currencies. Other nations responded with protectionist tariffs on imported goods and tit-for-tat currency devaluations of their own, strangling international trade and worsening the downward economic spiral.

Historical perspective is critical to understanding where we are now -- and what our nation may be facing even as we evaluate leading presidential contenders.

Money meltdown is not some remote topic to be relegated to abstruse scholarly articles published by universities, think tanks, and global institutions such as the International Monetary Fund. (Especially not the IMF, which long lost its mandate to preserve the Bretton Woods system of fixed exchange rates.) The consequences of currency chaos affect the personal fortunes of millions of individual citizens; once unleashed, it can spawn social resentments and political upheavals that change the destiny of whole nations.

We need to ask Sens. Barack Obama, Hillary Clinton and John McCain what they would do -- if anything -- to restore the integrity of the dollar as a meaningful unit of account, a reliable store of value. Would they put forward any new proposals for more comprehensive international monetary reform?

Given that Sen. Obama has garnered the support of Paul Volcker, the highly-respected former chairman of the Federal Reserve under Presidents Carter and Reagan, U.S. voters are apt to get a meaningful and well-considered reply. "I think we are skating on increasingly thin ice," Mr. Volcker noted in the Washington Post in April 2005. He warned that the stagflation of the 1970s was characterized by "a volatile and depressed dollar, inflationary pressures, a sudden increase in interest rates and a couple of big recessions." Mr. Volcker's solution? Act now to comply with "the oldest lesson of economic policy: a strong sense of monetary and fiscal discipline."

On the broader issue of global monetary reform, Mr. Volcker's ideas are less orthodox, more visionary. "My sense is that if we are to have a truly globalized economy, with free movement of goods, services and capital, a world currency makes sense," he stated in January 2000. "That would be a world in which the objectives of growth, economic efficiency and stability can best be reconciled."

Sen. McCain, for his part, suffers from an embarrassment of riches when it comes to economic advice.

One of his chief advisers is former Sen. Phil Gramm, a budget-balancing fiscal conservative with a Ph.D. in economics. Mr. Gramm is a disciple of the late Milton Friedman -- the Nobel laureate who furnished the academic rationale in the 1960s for ditching Bretton Woods and letting currencies float -- and might thus be expected to oppose any sweeping reforms to international monetary relations. Yet he has consistently emphasized the need "to refocus the IMF on its core mission of short-term lending to address financial and monetary instability." He considers protectionism "immoral."

Another McCain adviser, Jack Kemp, champions tax cuts and pro-growth policies over budgetary rigidity. A hero of the supply-side movement whose tireless efforts helped to bring about the Reagan boom of the 1980s, Mr. Kemp has never shied away from bold proposals.

Testifying before Congress in 1999, he criticized protectionist instincts that were misdirected at free and open trade "instead of the real source of the problem -- an international monetary arrangement of floating currencies in which no currency is linked to a stable anchor and all countries are tempted to use currency devaluation as an economic policy instrument during times of economic duress." Mr. Kemp's favored economic scholar is Robert Mundell, who received his Nobel for historical research on the operation of the gold standard and his theory of optimal currency areas. Considered the intellectual father of the euro, Mr. Mundell believes gold could be used as a reserve asset in a reformed international monetary system for the 21st century.

If the reality of a collapsing dollar and foreign exchange turmoil starts to bite consumers where they keep their pocketbooks -- for example, if the U.S. finds it necessary to raise interest rates to entice foreigners to buy the government bonds that finance our deficit -- the affects of currency misalignment could quickly move from the realm of dry treatises to the hyperactive world of live, televised political debate. Media consultants may grow apoplectic at the thought of having to reduce seemingly complex options into clever sound bites: Does the candidate advocate a new global monetary order linked to a universally-recognized reserve asset as a mechanism to guard against tinkering by self-serving governments? ("Gold: Money We Can Believe In.") Or is it possible to defend the existing, do-your-own-thing approach to currency relations, which undermines stable trade and capital flows at the expense of global prosperity? Meanwhile, foreign-exchange market specialists earn big profits by gambling -- some $3 trillion daily -- on where currencies might go next.

It's time the candidates devote less time on the minutiae of configuring the next economic stimulus package, or renegotiating the North American Free Trade Agreement. They should be thinking about how they will confront the imminent global currency crisis.

For a mathematical economist, Brian Wesbury has a great way of making complex things understandable IMO.

Government Failure, Or Market Failure? by Brian Wesbury, 3/24/08

Every time the US has an economic problem that causespain or fear (a recession, high energy prices, bank failures, or amarket crash) there is always a frantic look for scapegoats.And most often it is greedy corporations or otherwise nefariousprivate-sector-types that get the blame.

For example, many believe that energy companies aremanipulating oil prices. Politicians are always investigatingthem, and threatening legislation or special taxes. The GreatDepression, many believe, was caused by excessive greed.

Others think that Savings & Loans went belly-up because theydefrauded people and made bad loans. And today, there is aclear belief that subprime loans are all about greed and fraud.Some of this is true. Found in the rubble of each of theseeconomic upheavals are people who either made very baddecisions or committed fraud. But, a thorough look at theseeconomic problems shows how government policy mistakesplayed the key causal role in each of them.

The Great Depression was caused by excessively tightmonetary policy that began in the late 1920s. This createddeflation, and put upward pressure on the dollar, which in turnencouraged protectionism – the Smoot-Hawley Tariff Act wasthe result. Then Herbert Hoover raised tax rates in 1932, andFranklin Roosevelt ramped up regulation and governmentspending. The economy never stood a chance.

Richard Nixon closed the gold window, and devalued thedollar in the early 1970s. The Federal Reserve made hugemistakes, boosting inflation and undermining the dollar. Thisdrove up oil prices. Windfall profits taxes and energy pricecontrols made the problems worse.

In the late 1970s and early 1980s, Chicago’s Harris Bankwould not make oil loans if the oil in the ground was valued atmore than $20 per barrel. Penn Square Bank in Oklahomathought oil would stay high indefinitely and made billions of oilloans. It failed in 1982. The 8th largest US bank, Chicago’sContinental Bank, failed in 1984 partly because it hadpurchased $1 billion in oil and gas participations from PennSquare. In other words, the unexpected decline in oil pricesduring the early 1980s, when Paul Volcker successfully killedoff inflation, helped cause large bank failures. Harris was fine.

It wasn’t the bank failures that caused the recessions of theearly 1980s, it was Volcker’s unexpectedly tight money. Thistight money also undermined S&L’s. Double-digit short-termrates when many of the mortgages on their books had singledigitinterest rates turned them upside down. The losseseventually came to roughly $250 billion.

Today, just like in the past, the US is paying a hefty pricefor monetary policy mistakes. They began back in 1999 and2000 when the Fed tightened policy too much. This causeddeflationary pressures which the Fed reacted to by cuttinginterest rates to 1% in 2003. These 1% interest rates, and thebelief that they would stay low for a long time, led to excessesin housing, just like the excesses of oil lending were caused bycommodity inflation. And with mark-to-market accounting inplace today the problems compound even more quickly.

Some argue that since individual people made all thesedecisions, it’s not really the Fed’s fault. But this is like tellingsomeone after it’s been raining for 2 ½ years straight that theyshould not have sold their nice red convertible or wasted moneyon an umbrella now that it has stopped raining. Governmentfailure is more responsible for our current economic problemthan is generally realized. Arguing otherwise, and regulatingthe economy even more, risks compounding the government’salready large mistakes. It’s government failure that investorsshould worry about, not market failure.

Hillary's Bad HistoryMarch 31, 2008; Page A18No, not sniper fire in Bosnia. We're referring to Hillary Clinton's lament last week that the U.S. is flirting with a 1990s Japan-style deflation. Perhaps it's a good time to remind everyone what really happened in Japan, so Mrs. Clinton and the rest of Washington don't make the same mistakes.

"I don't think we can work our way out of the problems we're in in the broad-based economy with monetary policy alone," Mrs. Clinton said in the interview with Journal reporters. "I think the Japanese tried that and tried and tried that." She added Japan should have relied more on fiscal stimulus spending and aid to banks and homeowners, which is what she wants Washington to try now.

The Senator needs a refresher in Japanese economic history. Far from easing monetary policy, the Bank of Japan kept money too tight for too long in the early 1990s. Japan's stock market slide began in early 1990, but its central bank raised interest rates through most of that year and didn't cut them until July 1991. While the Bank of Japan eventually chased interest rates down to zero, it was always too late to break the deflationary spiral.

There's little sign the U.S. is facing a similar danger today, given that the Federal Reserve has been dropping rates quickly as the economy has slowed. If anything, the problem is the opposite, with the Fed risking future inflation by putting rates into negative real territory and devaluing the dollar. (See Ronald McKinnon nearby.)

Japan also made the mistake of refusing to make banks pay for the mistakes they made during their global lending spree in the late 1980s. As the world economy fell into recession in 1990, so did Japan. But rather than letting banks take their losses, the Liberal Democratic Party kept bailing them out. This merely delayed the day of reckoning, as insolvent banks were allowed to exist as "zombies," alive in name but unable to lend.

The government also raised consumption taxes, burdening consumers at exactly the wrong time. Meanwhile, with encouragement from the Clinton Treasury, Tokyo launched a vast Keynesian spending program. Roads, bridges, trains -- you name it, Japan built it. The nearby chart shows the impact this spending had on overall Japanese government debt, which exploded over the decade. The nearly annual spending programs led to several false recoveries with growth blips, but they never changed incentives enough to revive domestic risk-taking.

Yet this is exactly the policy that Mrs. Clinton now wants the U.S. to emulate. Rather than let housing speculators and lenders take the hit for mispricing credit and allow the market to clear, she wants a 90-day freeze on foreclosures and a five-year freeze on mortgage resets. She also wants the feds to buy up mortgage-backed securities and guarantee troubled mortgages. Rather than let housing markets find a bottom where they can begin a recovery, she and her allies in both parties would prolong the agony. While some homeowners and banks would be saved from foreclosure or greater losses, the cost would be to lengthen the housing recession.

A better model is the one the late Al Casey put into practice during the savings and loan crisis in the early 1990s. As president of the Resolution Trust Corp., Mr. Casey sold almost $400 billion of bankrupt assets as rapidly as he could. Declaring that his purpose was to "put the RTC out of business," Mr. Casey let investors buy those assets even at "vulture" prices. The real estate market was able to find a bottom, and the recovery came so fast that Bill Clinton inherited an economy that grew by 3.3% in 1992.

The Beltway class also now wants to indulge in the same Keynesian "stimulus" that failed in Japan. Mrs. Clinton's "Rebuild America Plan" would invest $10 billion over 10 years in an "Emergency Repair Fund" -- a plan she claims would create 48,000 jobs for every billion dollars spent, or close to half a million jobs. She would build ports, railroads, airports, public transit, tunnels and roads. Senate Democrats are proposing more than $35 billion in new spending -- on top of their $168 billion in tax rebates. These may also lead to false recoveries, but they won't ignite a new round of risk-taking and investment.

Japan finally emerged from its funk earlier this decade after it realized its bank losses and caught the updraft from global monetary reflation. Still, its economic growth remains mediocre -- a level that wouldn't be tolerated in the U.S. and may not be enough even in Japan. Sluggish growth has already sunk one Prime Minister and could prove fatal to the current leader, Yasuo Fukuda, whose approval ratings are dropping fast.

The way to revive U.S. growth is by learning from Japan's mistakes, and doing the opposite. The U.S. needs monetary policy that maintains a stable price level, bank supervision that recognizes mortgage losses and lets markets clear, and marginal rate tax cuts that boost incentives to work and invest. In short, the American policies of the 1980s, not those of Japan's lost decade.

See all of today's editorials and op-eds, plus video commentary, on Opinion Journal.

We are all too familiar with the problem of mortgage credit associated with the slump in home prices. The great unresolved puzzle in today's financial crisis is why some other private credit markets are seizing up.

The financial press is full of stories about a shortage of the U.S. Treasury bonds necessary in the multitrillion-dollar interbank market as collateral for borrowing by illiquid banks. This shortage seems even stranger in the face of a large federal fiscal deficit ($237.5 billion in 2007) that continually increases the supply of new Treasurys.

This shortage of Treasurys, and the unexpected severity of the credit crunch, is linked to the flight from the dollar in the foreign exchanges.

The U.S. Federal Reserve has hastily cut short-term interest rates to just 2.25% in March 2008 from 5.25% in July 2007. Unsurprisingly, private capital inflows for financing the huge U.S. trade deficit have dried up. Hot money has flowed out of the U.S. into those countries (of which China is the most prominent) with currencies that are most likely to appreciate.

Foreign central banks (apart from those in Europe) are then induced to intervene, sometimes massively, to buy dollars in order to slow their currencies' appreciations. In 2007, China had the biggest overall reserve buildup of $460 billion. Other central banks, from the Gulf oil-producing states to Russia, Brazil and some smaller Latin American and Asian countries, have also intervened to accumulate dollar reserves.

A substantial proportion of these official reserves is invested in U.S. Treasurys. The Federal Reserve's Flow of Funds data (March 2008) show that in 2007 foreign central banks accumulated about $209 billion of U.S. Treasurys. Somewhat inconsistently, the Treasury's own data show an accumulation of $250 billion.

Although acute in 2007 and more so going into 2008, this drain of Treasurys was also very large from 2003 to 2005. By early 2004, the federal funds rate had been cut to just 1%, which also triggered a flight from the dollar -- at that time more into yen than renminbi. This previous episode of easy money and unduly low interest rates greatly aggravated both the U.S. housing bubble and the more general overleveraging of the American financial system from 2003 to 2006.

In 2007-08, the crash in housing and the implosion of over-leveraged hedge funds, special investment vehicles and so on, has increased counterparty risk in most financial transacting. Illiquid financial institutions cannot effectively bid for funds by putting up suspect private bonds or loans as collateral. Unsurprisingly, there is a "flight to quality" that increases the private domestic demand for Treasurys. But this is happening at a time when the flight from the dollar in the foreign exchanges has greatly reduced their supply.

This increased demand coupled with a fall in supply helps explains why, in the midst of a U.S. credit squeeze with higher interest rates on private financial instruments, nominal interest rates on U.S. Treasury bonds have fallen to surprisingly low levels. Despite substantial ongoing U.S. price inflation of 4.3% in the consumer price index and 6.4% in the producer price index, Treasury yields are less than 1% on a three-month bill, 1.32% on a two-year note, and 3.5% on the benchmark 10-year bonds. There are even reports of effectively negative nominal yields on certain very short-term Treasurys. The real yield on Treasury Inflation Protected Securities has turned negative. (See chart.)

So we have a paradox. Despite the financial turmoil in the U.S. and its government's not-so-strong fiscal position, with huge contingent liabilities for guaranteeing private and public pensions as well as bailing out failing banks, its credit standing has strengthened. The fact that the U.S. government can market Treasury bonds at insultingly low interest rates at least provides an argument for using fiscal stimuli -- such as the $160 billion tax rebate passed in February 2008 -- to prop up the sagging U.S. economy.

Beginning on March 27, the Fed offered to lend banks and bond dealers as much as $200 billion of Treasurys from its own portfolio for up to 28 days, in return for a variety of collateral. The Fed was responding to complaints from dealers of a shortage of Treasurys in the interbank markets, but without recognizing that the root cause was the flight from the dollar in the foreign exchanges.

In the 1970s under the dollar standard, episodes of a weak and depreciating dollar led to monetary explosions in foreign trading partners, with world-wide inflationary consequences. Now, the inflation threat to the U.S. could be aggravated if foreign central banks intervene to prevent their currencies from appreciating too fast and overly expand their money supplies.

Stabilizing the dollar in the foreign exchanges and encouraging the return of flight capital to the U.S. will require two things. The first is to convince the U.S. Federal Reserve that continually cutting interest rates and expanding the U.S. monetary base is not the appropriate response to today's credit crunch; rather it triggers a vicious cycle.

The Fed responds to the credit crunch by cutting interest rates, which would be the seemingly correct textbook strategy if the economy were closed and the foreign exchanges could be ignored. But the economy is open, and capital flies out of the country. Because of the unique position of the U.S. at the center of the world dollar standard, the drain of Treasurys -- the prime collateral in impacted credit markets -- exacerbates the credit crunch, and monetary expansion abroad worsens world-wide inflation. The Fed then further expands in response to the tightening of U.S. credit markets.

The second component of a strong dollar policy is more direct action on exchange rates. At the very least, China bashing as a means to force dollar depreciation against the renminbi should end. The U.S. government should also cooperate with central banks in Europe, Japan, Canada and elsewhere to stabilize the sinking dollar.

The best solution to the current crisis is to stop the flight from the dollar. This would be beneficial beyond relieving the drain of Treasurys and relaxing the crunch in American credit markets. Letting the dollar depreciate without any convincing action to secure its long-term value against other major currencies undermines confidence in the dollar's long-term purchasing power. It also lets the inflation genie out of the bottle, and makes a return to 1970s-style stagflation look imminent.

Mr. McKinnon is a professor at Stanford University and a senior fellow at the Stanford Institution for Economic Policy Research.

'10% of GDP'April 17, 2008; Page A18Is Washington looking in the wrong place for financial market risk to taxpayers? According to a new study by Standard & Poor's, the answer is yes.

Congress is disturbed about the bailout risk from the Federal Reserve opening its discount window to borrowing from investment banks and broker-dealers. That's a reasonable concern, especially with the Fed guaranteeing $29 billion in dodgy Bear Stearns paper. But according to S&P, the "maximum potential cost" of bailing out Wall Street would be below 3% of GDP, assuming a deep and prolonged recession. That's painful, but not catastrophic.

Guess where the far greater danger comes from? If you said Fannie Mae and Freddie Mac, you are a faithful reader of these columns and we bow before you. According to the S&P study, the taxpayer risk from Fan and Fred, combined with that of other government-guaranteed agencies, "yields a potential fiscal cost to the government of up to 10% of GDP." With total U.S. GDP estimated at somewhere north of $14 trillion, that would put the Fan and Fred bailout cost at about $1.4 trillion. Yowza. This "fiscal burden" would be so large, in fact, that S&P figures it could even jeopardize the AAA credit rating of the U.S. government.

These are the same two companies, by the way, that have recently had their capital requirements reduced and their jumbo mortgage lending limits increased to a maximum of $729,750. New York Senator Chuck Schumer, among many others on Capitol Hill, had browbeaten the Bush Administration until it eased those limits. Capital is of course the only cushion taxpayers have against a bailout if Fan and Fred keep racking up losses. Better hope this recession isn't deep.

Greetings, it's me again, giving more advice and taking you up on your thoughtful suggestion to open up a national discussion and dialogue on race and racial reconciliation in America.

First of all, some historical perspective, not for you senator, but for my other readers.

I believe all great achievements in our nation's progress toward social, legal and economic justice have been led by a combination of agitation and idealism. From the Founders in 1776, to the Civil War waged to save the union and abolish slavery, to the Civil Rights Movement which began to fully integrate African Americans into the electoral and economic mainstream, we have wrestled with, debated and discussed the next steps that are needed toward "a more perfect Union."

Each great era of progress was led by men and women of conviction who challenged us to live up to the highest ideals of our nation, who declared in a very radical way that we are all God's children. This ideal was not even close to reality until the passage of the 1964 Civil Rights Act and the 1965 Voting Rights Act, both of which were aimed at abolishing the last vestiges of the evil practices known collectively as "Jim Crow."

This month I thought about April 15 not just in terms of taxes (they're too high and complex), but because of a great African-American agitator, Jackie Robinson, who broke the color barrier in baseball on that date and helped lead all professional sports to higher levels of excellence and performance.

Barack, as we fast-forward to today, I contend we've successfully integrated the U.S military, the arts and entertainment, and sports at all levels. The one area of American life that is still very separate and very, very unequal is our economy. Many people of color have risen spectacularly against the odds – Oprah Winfrey, Bob Johnson, Magic Johnson, Whoopi Goldberg and many other professional athletes, entertainers and businessmen and women of whom we can be proud. Still, we need to look at all those left behind, all those you have spoken of who today lack economic opportunity to climb the ladder of wealth, ownership and asset creation so central to achieving the American Dream.

As Jesse Jackson said at a Wall Street Project conference I attended, "Capitalism without capital is nothing but an ism." Truer words were never spoken. Look at the great fortunes generated by the Carnegies and Mellons, the Rockefellers, Guggenheims and others. These were established in an economic climate of sound money with very low taxes on income, estates and capital gains.

Before you start thinking, "There goes Kemp again, calling for a kind of laissez-faire approach to capitalism," let me note that incentives in the tax code to encourage investment have been championed at one time or another by both political parties – from Coolidge to Kennedy and from Reagan to Rangel. (Charlie Rangel to a lesser degree, but my old friend co-sponsored enterprise zones, with Joe Lieberman and me, that actually zeroed out capital gains taxes and has called for a cut in corporate income tax rates.)

In my opinion, people of all colors and income levels don't hate the rich. They want to get rich. They're more interested in generating wealth than they are in redistributing wealth. They want to own property, educate their children and build a nest egg that can be passed on to their heirs. Unfortunately, some aren't able to access the same ladder of opportunity that is so readily available to the majority.

As I'm fond of saying, you can't get rich on wages, you have to earn, save, invest, reinvest and pass on to your children the products of your labors.

Senator, I believe our tax code punishes this process of upward mobility, especially for people of color, and in some cases it actually prevents people from escaping poverty. In this respect, I believe your economic views are short-sighted. You've pledged to raise income tax rates to 39.5% and lift the cap on payroll taxes, which would end up raising the top rate on income to 52% or more. You also want to raise dividend taxes to 39.5% and capital gains to 28%, plus you want to return to a confiscatory 55% "death tax." Unwittingly, your plans would prohibit most black Americans, indeed most Americans, from ever getting rich or even richer. Your economic ideas, sincere as they are, would weaken the economy, weaken the dollar, and weaken our chances of reducing poverty and unemployment.

It's my strongly held belief that we should be working to democratize our free-enterprise, private property-based system. We can do this by expanding empowerment zones and offering zero capital gains taxes for those who invest there; by reforming the tax code to open access to capital; and by providing more school choice in urban America.

As for the housing sector, we should listen to my former colleague Bruce Bartlett, who has called for the repeal of this year's $117 billion tax rebate, and to redirect the money into a package of measures that would help those homeowners who actually need assistance to save their homes.

By giving people access to capital and allowing them to take ownership of assets, entrepreneurship will be encouraged and the cycle of poverty can begin to be broken. All persons should have the opportunity to go as high as their merit and determination can carry them. My favorite quote is from Abraham Lincoln, who said, "I don't believe in a law to prevent a man from getting rich; it would do more harm than good. So while we do not propose any war upon capital, we do wish to allow the humblest man an equal chance to get rich with everybody else."

Lincoln's definition of entrepreneurial capitalism is the best I have ever heard. I believe that a bipartisan consensus could be reached in America on a 21st-century war on poverty that takes the best of the "center left" and the best of the "center right" on the reforms necessary to make the American Dream accessible to all our people. We may have a long way to go, but I remain an optimist about improving the human condition, expanding our democratic ideals, and forming a true partnership with private enterprise.

I love what Bobby Kennedy said in Bedford-Stuyvesant in 1968: "To ignore the potential contribution of private enterprise is to fight the war on poverty with a single platoon, while great armies are left to stand aside."

Barack, let's get together with, say: John Bryant of Operation Hope in Los Angeles; Ambassador Andrew Young of Good Works International; Bob Woodson of Neighborhood Enterprise Foundation in Washington, D.C.; Ted Forstmann of Forstmann Little & Company in New York; Russell Redenbaugh, a U.S. civil rights commissioner in Philadelphia; and economist Art Laffer. We can discuss how best to tackle the issue you raised in your March 18 speech, when you identified the lack of economic opportunity for people of color as one of our nation's greatest challenges.

Any interest, sir?

Mr. Kemp is a former congressman, the 1996 Republican vice presidential candidate, and a former secretary of Housing and Urban Development.

Well, here you are at your college graduation. And I know what you're thinking: "Gimme the sheepskin and get me outta here!" But not so fast. First you have to listen to a commencement speech.

Don't moan. I'm not going to "pass the wisdom of one generation down to the next." I'm a member of the 1960s generation. We didn't have any wisdom.

We were the moron generation. We were the generation that believed we could stop the Vietnam War by growing our hair long and dressing like circus clowns. We believed drugs would change everything -- which they did, for John Belushi. We believed in free love. Yes, the love was free, but we paid a high price for the sex.

My generation spoiled everything for you. It has always been the special prerogative of young people to look and act weird and shock grown-ups. But my generation exhausted the Earth's resources of the weird. Weird clothes -- we wore them. Weird beards -- we grew them. Weird words and phrases -- we said them. So, when it came your turn to be original and look and act weird, all you had left was to tattoo your faces and pierce your tongues. Ouch. That must have hurt. I apologize.

So now, it's my job to give you advice. But I'm thinking: You're finishing 16 years of education, and you've heard all the conventional good advice you can stand. So, let me offer some relief:

1. Go out and make a bunch of money!

Here we are living in the world's most prosperous country, surrounded by all the comforts, conveniences and security that money can provide. Yet no American political, intellectual or cultural leader ever says to young people, "Go out and make a bunch of money." Instead, they tell you that money can't buy happiness. Maybe, but money can rent it.

There's nothing the matter with honest moneymaking. Wealth is not a pizza, where if I have too many slices you have to eat the Domino's box. In a free society, with the rule of law and property rights, no one loses when someone else gets rich.

2. Don't be an idealist!

Don't chain yourself to a redwood tree. Instead, be a corporate lawyer and make $500,000 a year. No matter how much you cheat the IRS, you'll still end up paying $100,000 in property, sales and excise taxes. That's $100,000 to schools, sewers, roads, firefighters and police. You'll be doing good for society. Does chaining yourself to a redwood tree do society $100,000 worth of good?

Idealists are also bullies. The idealist says, "I care more about the redwood trees than you do. I care so much I can't eat. I can't sleep. It broke up my marriage. And because I care more than you do, I'm a better person. And because I'm the better person, I have the right to boss you around."

Get a pair of bolt cutters and liberate that tree.

Who does more for the redwoods and society anyway -- the guy chained to a tree or the guy who founds the "Green Travel Redwood Tree-Hug Tour Company" and makes a million by turning redwoods into a tourist destination, a valuable resource that people will pay just to go look at?

So make your contribution by getting rich. Don't be an idealist.

3. Get politically uninvolved!

All politics stink. Even democracy stinks. Imagine if our clothes were selected by the majority of shoppers, which would be teenage girls. I'd be standing here with my bellybutton exposed. Imagine deciding the dinner menu by family secret ballot. I've got three kids and three dogs in my family. We'd be eating Froot Loops and rotten meat.

But let me make a distinction between politics and politicians. Some people are under the misapprehension that all politicians stink. Impeach George W. Bush, and everything will be fine. Nab Ted Kennedy on a DUI, and the nation's problems will be solved.

But the problem isn't politicians -- it's politics. Politics won't allow for the truth. And we can't blame the politicians for that. Imagine what even a little truth would sound like on today's campaign trail:

"No, I can't fix public education. The problem isn't the teachers unions or a lack of funding for salaries, vouchers or more computer equipment The problem is your kids!"

4. Forget about fairness!

We all get confused about the contradictory messages that life and politics send.

Life sends the message, "I'd better not be poor. I'd better get rich. I'd better make more money than other people." Meanwhile, politics sends us the message, "Some people make more money than others. Some are rich while others are poor. We'd better close that 'income disparity gap.' It's not fair!"

Well, I am here to advocate for unfairness. I've got a 10-year-old at home. She's always saying, "That's not fair." When she says this, I say, "Honey, you're cute. That's not fair. Your family is pretty well off. That's not fair. You were born in America. That's not fair. Darling, you had better pray to God that things don't start getting fair for you." What we need is more income, even if it means a bigger income disparity gap.

5. Be a religious extremist!

So, avoid politics if you can. But if you absolutely cannot resist, read the Bible for political advice -- even if you're a Buddhist, atheist or whatever. Don't get me wrong, I am not one of those people who believes that God is involved in politics. On the contrary. Observe politics in this country. Observe politics around the world. Observe politics through history. Does it look like God's involved?

The Bible is very clear about one thing: Using politics to create fairness is a sin. Observe the Tenth Commandment. The first nine commandments concern theological principles and social law: Thou shalt not make graven images, steal, kill, et cetera. Fair enough. But then there's the tenth: "Thou shalt not covet thy neighbor's house. Thou shalt not covet thy neighbor's wife, nor his manservant, nor his maidservant, nor his ox, nor his ass, nor anything that is thy neighbor's."

Here are God's basic rules about how we should live, a brief list of sacred obligations and solemn moral precepts. And, right at the end of it we read, "Don't envy your buddy because he has an ox or a donkey." Why did that make the top 10? Why would God, with just 10 things to tell Moses, include jealousy about livestock?

Well, think about how important this commandment is to a community, to a nation, to a democracy. If you want a mule, if you want a pot roast, if you want a cleaning lady, don't whine about what the people across the street have. Get rich and get your own.

Now, one last thing:

6. Don't listen to your elders!

After all, if the old person standing up here actually knew anything worth telling, he'd be charging you for it.

P.J. O'Rourke, a correspondent for the Weekly Standard and the Atlantic, is the author, most recently, of "On The Wealth of Nations." A longer version of this article appears in Change magazine, which reports on trends and issues in higher education.

October 25, 2005, 8:27 a.m.Moore Hypocrites Than True Believers?Exposing the Do As I Say (Not As I Do) Left.

Q&A by Kathryn Jean Lopez

The mother of Princeton bioethics professor Peter Singer is lucky that her son is an hypocrite. Her son is a leading proponent of excising the undesirable — the imperfect via abortion, infanticide, and euthanasia. The disabled would fall under there, also, sometimes, the elderly.

Peter Singer's mother has Alzheimer's.

Peter Schweizer reports in his new book Do As I Say (Not As I Do): Profiles in Liberal Hypocrisy that "far from embracing his own moral ethic, Singer hired a group of health care workers to look after her."

Good for him, he can't even buy his own poison. (When your ideas are destructive, at least a little hypocrisy saves a life here and there, despite the widespread damage you may be doing.)

Singer isn't the only hypocrite on the Left. Hoover Institution fellow Schweizer exposes a handful of popular Lefty hypocrites in his new book. He recently talked to National Review Online editor Kathryn Lopez about his latest book and the Left's deficiencies.

KATHRYN JEAN LOPEZ: Michael Moore makes money off oil and war? Why would he bother lying about owning stock? Is Peter Schweizer the only person who bothered checking?

PETER SCHWEIZER:Michael Moore is constantly trying to prove his and the Left's moral superiority, so he says things about himself that are patently not true. He's pathological about it. How else to explain that he's loudly proclaimed no less than three times that he doesn't invest in the stock market because it's morally wrong while quietly picking up shares in a whole host of companies. A portfolio that includes Halliburton, Boeing, and HMOs doesn't fit the bill so he lies about it. I think he assumed that no one would poke around and investigate. When it comes to the MSM he was correct in making that assumption. He never responded to my questions. I'm dying to know how he explains away this one.

LOPEZ: Where did you get the idea for Do As I Say...? Did you just know the line of inquiry would be productive or did something fall into your lap?

SCHWEIZER: I got tired of having discussions and arguments with people on the Left who operate on the assumption that they possess the moral high ground. They're not greedy, they're the only ones who truly care about the poor, minorities, you name it. Knowing quite a few people on the Left I knew that wasn't true. So I started poking around — looking at tax returns, IRS filings, court documents, etc. Frankly, it's amazing how easy it was to find examples of lefties being completely hypocritical.

LOPEZ: Given the hypocrisy you expose on this front, please tell me Nancy Pelosi at least isn't a Wal-Mart basher.

SCHWEIZER: Nancy Pelosi bashes everyone who doesn't allow unions to call the shots. Everyone that is except herself. It's takes an amazing amount of gall to accept the Cesar Chavez Award from the United Farmworkers Unions while using non-UFW workers on your Napa Valley Vineyard. It takes the same to praise the Hotel Employees and Restaurant Employees Union and take massive sums of money from them all the while keeping them out of your Hotel and chain of restaurants. But again, I think Pelosi correctly assumes that no one in the media will challenge her on this.

LOPEZ: I'm all for having a little legitimate fun with liberals. But doesn't revealing Barbra Streisand's water bill feel a little like going through her garbage? Actually: Did you have to go through her or anyone else's garbage? Where did you get this stuff?

SCHWEIZER: I didn't go through Bab's trash. All the info in the book was obtained legally and ethically. Streisand's annual water bill of $22,000 to keep her lawn green is relevant because she made it relevant: She's constantly lecturing ordinary Americans about the need to cut back on our consumerist culture. Maybe if she turns off the taps she'll have some legitimate grounds for making the claims she does. As Kermit the Frog said, it's not easy being green.

LOPEZ: Um and the Clinton's underwear? Though the Clinton's claiming $4 per pair of used underwear among their charitable contributions does seem like it is begging for a New York Post cover.

I suppose there was not blue dresses. Something like that would make a lot more on ebay.

SCHWEIZER: Ah, yes, the Clintons, who profess to pay the maximum amount on their taxes every year because it's the right thing to do. The Clintons are simply amazing in their ability to lecture Americans about their need to pay more taxes while at the same time finding lucrative tax shelters and taking outrageous tax deductions. Again, the media gives them a free pass.

LOPEZ: What else about the Clintons do you want to hand over to RNC op research before 2008?

SCHWEIZER: I think their record of greed, jilting poor people out of their money, and their avarice are a sight to behold. Let people see how they have made their money over the last couple of decades and it speaks for itself.

LOPEZ: Tell me the great hypocrisy of that greatest of all public intellectuals according to one recent depressing survey: Noam Chomsky.

SCHWEIZER: Noam Chomsky thinks he's the Moses of this age and even those on the Left who don't agree with him on everything accept his moral authority. But Chomsky is a socialist who practices capitalism, and an anti-militarist who has made millions off of Pentagon contracts. Wonder what his followers would think of that? Then there is his constant lecturing about "tax gimmicks" and "tax shelters" that "the rich" use to avoid paying their "fair share." He must have forgotten about that when he set up his tax shelter.

LOPEZ: And he wasn't a lot of fun when you got in touch with him, was he?

SCHWEIZER: I give credit to Chomsky for responding to my questions. His excuses were something to behold. No wonder he teaches linguistics. It's amazing how he twists his words. By the way, he said it was okay to criticize other rich people for setting up trusts and setting one up himself. After all, he explained, he's been fighting for poor people his whole life.

SCHWEIZER: I'm not sure that most people take Franken seriously, but the media most assuredly does. He professes to be more than a comedian. He claims to be a political analyst and apparently wants to be a U.S. senator. (His former writing partner says he really wants to be president. Yikes!) His vicious attacks against conservatives as racists are not meant to be funny. He really does think that we're bigots. So questions about his absolutely abysmal record when it comes to hiring minorities should be exposed. (For those who want a hint, less than one percent of his employees have been black. That's a worse record than Bob Jones University, which Franken claims is "racist.")

LOPEZ: So he lies you say? At heart, he's a comedian. Does it really matter?

SCHWEIZER: Yes it does matter. Among the liberal/Left base, they see Franken as some sort of prophet who speaks the truth. And again, the media gives him a free pass. I caught him on The Late Show with David Letterman last Friday. They chuckled a bit and Franken went on to explain his twisted and distorted view of the world. He wasn't challenged on anything he said.

LOPEZ: About Franken, he wanted to fight our Rich Lowry. You nervous now that your book is out?

SCHWEIZER: I tried to get Franken to answer my questions. I wanted him to explain some of the outrageous comments he made a few years ago about disliking homosexuals and the fact that he was glad one had been killed. (Imagine if a conservative had said that?) And I wanted to ask him why he considered conservatives and Republicans racist because they hired so few blacks when he had such a horrible record himself. Alas, he never responded.

About the Lowry-Franken fight: Rich is too classy to take him up on it but I wish he had. He could have taken him easy.

LOPEZ: Any Lefties you checked into who came out with flying non-hypocritical colors worth lauding for at least practicing what they preach?

SCHWEIZER: I really thought that Ralph Nader would be that man. He lives a monk-like existence and tends to shun the material things in life. But then I discovered that he fired some of his employees for trying to form a union and I realized he wouldn't fit the bill. I'm still looking....

LOPEZ: Another say-something-nice question: Is there anyone on the Left you admire? Or are you a hater?

SCHWEIZER: I don't admire the ideas of the Left but there are some individuals that I think demonstrated integrity and honesty. Senator Paul Wellstone — say what you will about him, but he seemed to at least try to live a life somewhat consistent with his principles.

LOPEZ: Were you depressed or invigorated by the big wigs of the Left's hypocrisy?

SCHWEIZER: Invigorated. It's another reminder that the ideas the left want to impose on the rest of us are so fundamentally bad that they don't even try to live by them. At the end of the day, when all the fun is done, I hope people view this as a book about ideas and the failure of liberal/Left ideas. They don't work for the leading lights of the Left. How could they possibly work for our country?

LOPEZ: One overarching kinda question: We all have our moments of hypocrisy. That we don't practice what we preach doesn't make what we preach any less valid. People are human, etc. Is there something about your book that is somewhat fundamentally unfair?

SCHWEIZER: Yes, we are all hypocrites and I talk about that in the book. But liberal hypocrisy and conservative hypocrisy are quite different on two accounts. First, you hear about conservative hypocrisy all the time. A pro-family congressman caught in an extramarital affair, a minister caught in the same. This stuff is exposed by the media all the time. The leaders of the liberal-Left get a complete pass on their hypocrisy. Second, and this is even more important, the consequences of liberal hypocrisy are different than for the conservative variety. When conservatives abandon their principles and become hypocrites, they end up hurting themselves and their families. Conservative principles are like guard rails on a winding road. They are irritating but fundamentally good for you. Liberal hypocrisy is the opposite. When the liberal-left abandon their principles and become hypocrites, they actually improve their lives. Their kids end up in better schools, they have more money, and their families are more content. Their ideas are truly that bad.

LOPEZ: Is there something about the book that sums something up philosophically about the Left?

SCHWEIZER: After researching the book I really truly believe that the leading lights of the Left — Moore, Franken, Clinton, Pelosi, Kennedy, etc. — really honestly don't believe what they are selling us. Their own experiences teach them that their ideas don't work.

LOPEZ: So I can't stand Michael Moore anyway. I really don't need any more anger aimed in his direction. Ditto with some others who get chapters in your book. Why should I read your book anyway? How might a Michael Moore fan get something out of Do As I Say...?

SCHWEIZER: All I would ask a Michael Moore fan do is look at the facts. Moore professes to hate capitalism ("the last evil empire" he's called it) but practices it in spades. Moore condemns people for their racism and claims to support and practice affirmative action, but has a lousy record of hiring minorities. He outsources post-production film work to Canada so he can pay non-union wages. I could go on and on. I would ask his fans: is this really a sincere person?

LOPEZ: You always seem to have projects going on. What's next for you?

SCHWEIZER: Right now I'm working to promote the book. I have some ideas for future projects but nothing set in stone. I wrote a novel with Cap Weinberger that came out a couple of months ago called Chain of Command. Cap is a class act and I enjoyed writing fiction. Maybe another novel at some point. We'll see.

LOPEZ: What's the funniest story you learned while compiling the book?

SCHWEIZER: It has to be one about Michael Moore. In his books Michael Moore goes on and on about the fact that Americans are racist because they live in white neighborhoods. It's an example of latent segregationist attitudes in his mind. When I checked the demographics on Michael Moore's residence I burst out laughing. Michael Moore lives in a town of 2,500 in Michigan. According to the U.S. Census Bureau, there is not a single black person in the entire town.

The author fails to discuss BO's approach to capital gains taxes wherein he admits he would raise rates even though it would yield less revenues, but I post it anyway because I think his point about bracket creep a worthy one.================

Obama's Faulty Tax ArgumentBy ANDREW G. BIGGSMay 9, 2008; Page A17

As the presidential campaign heats up, a key issue is whether to extend the 2001 and 2003 income tax cuts, which expire in 2011. John McCain wants to make the tax cuts permanent. Barack Obama and Hillary Clinton want to let the rates rise.

Opponents of the tax cuts point to spending programs that could be financed by the extra revenues. Chief among these is Social Security. Sen. Obama's Web site, for example, argues that "extending the Bush tax cuts will cost three times as much as what is needed to fix Social Security's solvency over the next 75 years."

Such statements imply that if we return to the seemingly modest tax rates of the 1990s, we could fund the $4.3 trillion Social Security deficit, and so much more. As Mr. Obama recently told Fox News, "I would roll back the Bush tax cuts on the wealthiest Americans back to the level they were under Bill Clinton, when I don't remember rich people feeling oppressed."

This argument seems compelling, but it is misguided. In reality, repealing the tax cuts would raise taxes far above Clinton-era levels. Due to quirks in the tax code, average taxes would be almost 25% higher than during the 1990s.

Mr. Obama's claim that the lost revenue from the income-tax cuts exceeds the Social Security shortfall derives from an analysis by the Center on Budget and Policy Priorities. The Center's conclusions have been widely cited, but rely on dubious assumptions.

The basic methodology is simple: Compare the income-tax revenues if the tax cuts expire to revenues if the tax cuts are extended. The Center measures the difference in revenue 10 years from now – to match the government's 10-year budget measurement period – then extends the difference over 75 years to make it comparable to the 75-year Social Security shortfall.

To account for the effects of inflation and economic growth, analysts compare tax revenues to the size of the economy. The Congressional Budget Office projects that if the tax cuts expire, income-tax receipts in 2018 will be 1.5% higher relative to gross domestic product than if the cuts are made permanent. By comparison, Social Security's 75-year shortfall is just 0.6% of GDP.

So Social Security is a costly problem, but the tax cuts cost much more. Open and shut case, right?

Not exactly. Tax revenues would skyrocket if the tax cuts expire, due to "bracket creep." Average incomes are higher today than in the 1990s, but income-tax brackets aren't adjusted for the growth of earnings. As a result, Americans will shift into higher tax brackets and pay a greater share of their incomes in taxes.

Going back to the tax rates of the 1990s doesn't mean that households will pay 1990s taxes. Because the tax brackets haven't risen along with incomes, average taxes would be significantly higher, and grow each year.

If the tax cuts expire, income-tax revenues by 2018 will rise to 10.8% of the total economy from 8.7% today – an increase of 24%. Compared to the average over the last 50 years, allowing the rates to rise would increase tax revenues by 32%.

Believe it or not, income taxes will rise even if the tax cuts remain in place, because the revenue-increasing effects of bracket creep more than offset the lower rates. With the lower rates, total income-tax revenues will increase to 9.3% of GDP by 2018. This level is 7% higher than today, and 13% above the 1957-2007 average. Thus even with the tax cuts, revenues will increase by more than enough to fix Social Security.

So even if the tax cuts are made permanent, future Americans will pay a greater share of their incomes to the government than in the past. But for some in Washington, that's not enough.

Not surprisingly, neither party highlights these rising tax receipts. They undercut liberal arguments that the government is starved of revenue. And they render conservative claims for the tax cuts unimpressive. ("Vote GOP: A smaller tax increase than the other guys!")

The next president will face difficult choices regarding how much to collect in taxes, and how much to spend on entitlements like Social Security. Future citizens may decide that paying higher taxes is worthwhile. But in any event, the misleading tax cuts vs. Social Security argument should not guide policy makers on this issue.

Mr. Biggs, a resident scholar at the American Enterprise Institute in Washington, D.C., is the former principal deputy commissioner at the Social Security Administration.

Geopolitical Diary: Asian Banks and Rising Commodity PricesMay 28, 2008Export-based economies that depend on a steady stream of dollars are beginning to feel the effects of an economic slowdown in the United States. This was evident Tuesday when central banks in Indonesia, the Philippines, Taiwan and South Korea began selling dollars in what is most likely an effort to strengthen their currencies against the dollar — a conscious decision to demote the importance of cheap exports in favor of controlling inflation.

Typically, East Asian countries hoard dollars in order to keep their own currencies weak. Weak currencies translate into lower prices and higher demand from foreign markets which in turn supports the export-centric East Asian economies. But this system works best when the dollar is strong and the price low for raw material like minerals (including oil), building supplies and food.

Right now this is not the case. With oil at $130 per barrel, grain prices at record highs and raw materials in fierce demand, the situation is becoming dire for manufacturing economies.

The currency-strengthening move undertaken by the central banks Tuesday is a shift in policy. Historically, a weak-currency export strategy has been a mainstay in East Asian economies. In fact, Japan, Taiwan, South Korea and Singapore all dragged themselves out of post World War II doldrums using this strategy. Since then, they have migrated from manufacturing-based economies to ones that are technological and service-centered. Others like Indonesia (which is still largely agriculturally based) are also hurting from the recent rise in commodity, energy and food prices but not to the degree of a manufacturing-based economy.

The recent currency manipulation strategy raises the specter of the East Asian financial crisis, set off by the Thai government’s decision in 1997 to float the baht. While the events Tuesday do not necessarily signal the beginning of another crisis, they certainly show that at least a few East Asian countries have hit some sort of threshold. They can no longer keep up with rising commodity prices. While Indonesia, the Philippines, Taiwan and South Korea are lower- and mid-level economies in East Asia, the decisions by their central banks are important, especially as a sign of what may come.

In fact, the real pain from high commodity prices is not necessarily being felt by the countries that tinkered with their currencies Tuesday, but by China and Thailand. As of 2006, manufacturing made up 41 percent and 35 percent of the Chinese and Thai economies respectively. By far, these countries operate the most manufacturing-dependent economies in East Asia.

In China and Thailand, factories are the backbone of the economy. In order to fuel the machines that produce the goods, these economies demand electricity, heat and large amounts of commodities ranging from iron to copper to platinum. Trucks, trains and boats are required to get those products to port and all consume fuel also. Compared to economies such as Japan, which is much more technology- and service-based, China and Thailand use far more energy and raw materials per dollar of wealth created.

Therein lies their weakness. China in particular is feeling the pain of high commodity prices. Like the other East Asian countries, it also has an export-based economy. But China’s case is special in that its top priority is political stability — a balance derived by providing its people with basic requirements like food. Thus far, China has been successful in doing so by reaping the benefits of a red-hot economy that has brought it wealth at a rapid pace. But rising commodity prices threaten the country’s economy and political stability in two ways. First, the high cost of raw materials and energy means that factories are seeing their already-tight profit margins shrink even further. Second, the rising cost of food can quickly lead to social upheaval if workers cannot afford to feed their families.

Although it has not employed the same methodology as the central banks on Tuesday, China has been taking action to strengthen its currency gradually since July 2005 — not by selling off dollars that it holds, but by making its yuan policy more flexible.

While other countries can buy breathing room by selling off chunks of U.S. dollars, the same luxury does not exist for China. If the yuan stays relatively weak against the dollar, then the country will continue to suffer high commodity prices and become vulnerable to food and energy shortages and thus social unrest. However, if China suddenly ramps up the current gradual strengthening of the yuan, then it risks shuttering factories that depend on exports and thus increasing unemployment. China also runs the risk of devaluing a significant portion of the approximately $1.7 trillion in savings it holds in foreign exchange reserves.

Ultimately, these actions — and those taken by the central banks Tuesday — do not change the fact that China, like all manufacturing-heavy economies, is in for some challenging times ahead.

That Stagflation ShowJune 9, 2008; Page A16Friday's market rout in employment, oil, the dollar and stocks was not the end of the world, but it is a warning. The message is that the current Washington policy mix of easy money and Keynesian fiscal "stimulus" is taking us down the road to stagflation.

Stocks hit the skids following a plunge in the dollar and a nearly $11 leap in the oil price, which in turn followed a jump in the jobless rate to 5.5% in May from 5%. Investors are guessing that the weak jobs report means that the Federal Reserve won't follow through on its recent pledge to defend the dollar. That sent the dollar lower and gold and oil (which is denominated in dollars) soaring, which in turn adds to doubts about future economic growth. The market foreboding concerns a rerun of "That '70s Show" of higher prices but mediocre growth.

Washington has been on this path in earnest since the credit market blowup last August. The Fed slashed interest rates dramatically to save Wall Street and prevent a recession, ignoring the risk to the dollar. Meanwhile, Congress and the White House agreed to about $168 billion in "stimulus," mainly in the form of tax-rebate checks to prop up consumer spending. If you don't feel stimulated by this repeat of nostrums from the 1970s, join the club.

The Fed's strategy has triggered a dollar rout and commodity boom that has sent food and energy prices soaring. The nearby chart shows how oil prices have risen as interest rates have fallen. This commodity spike has made a recession more likely, not less. The trend is ominous enough that early last week Fed Chairman Ben Bernanke finally dropped his not-so-benign neglect and talked up the dollar; oil prices fell.

But Friday's markets show that investors still have little confidence in the Fed's ability to resist political pressure to keep easing money. A day earlier, European Central Bank President Jean-Claude Trichet signaled that he'll soon raise rates no matter what the Fed does. Mr. Trichet is right not to want to repeat the Fed's mistake, but his action didn't help confidence in the greenback.

As for those rebate checks, they were promoted in January by the Democratic Party's main policy intellectuals, including former Treasury Secretaries Robert Rubin and Larry Summers. The idea was that the rebates would tide the economy over until the credit crunch passed and the Fed's easy money began to work. The checks have been at least one-third distributed, and we're still waiting for their growth kick. Much of the cash is going to pay for $4 gasoline and higher food prices. In any event, such temporary rebates provide at best a short-term lift to consumer spending and do nothing to change the incentives to save or invest.

The White House acquiesced for the sake of bipartisan amity and the appearance of "doing something." Yet now that the jobless rate is rising, Democrats are blaming Republicans anyway. As a political matter, Republicans would have been better off fighting in January for tax cuts that stimulated something other than new Democratic voters. Instead, they've added $168 billion to the deficit without any growth payback.

The vast, diverse U.S. economy has shown remarkable resilience, and left to its own devices its natural tendency is to grow. But the problem looking forward is the Washington policy consensus. Mr. Bernanke continues to blame the commodity spike on a change in "relative prices" caused by growing demand for oil, even though demand is falling as the world economy slows.

Last week, Mr. Bernanke also explicitly rejected any comparison to the 1970s. The fact that he felt he had to defend himself on that score is telling. We prefer to stick with Paul Volcker, who lived through the 1970s and has said publicly that today's policy explanations sound exactly like those that were used to justify easy money in the early part of that lost economic decade. The Fed has to protect the dollar with deeds, not words.

Meanwhile, the born-again Democratic Keynesians are already demanding a second round of nonstimulating stimulus. They now want tens of billions of dollars in new public spending and a housing bailout this year, while in stark contradiction promising a huge tax increase to reduce the deficit next year. The one thing they rule out is a tax cut that would work.

None of this means Republicans have to repeat their January error. John McCain has a chance to break with this Beltway consensus and offer a pro-growth policy mix. To wit, tighter money to defend the dollar, burst the oil bubble and protect middle-class purchasing power; and marginal, immediate and permanent tax cuts to boost incentives and restore risk-taking.

No doubt Democrats would block a tax cut in Congress this year, and Barack Obama would say it's for the rich. But this is a fight Mr. McCain should welcome. Without his own economic narrative and policy breakout, Mr. McCain will find himself lashed to the status quo and playing defense. The markets are saying they don't want a repeat of the 1970s, and if they aren't heeded the voters will deliver the same message in November.

See all of today's editorials and op-eds, plus video commentary, on Opinion Journal.

Imagine how Americans would feel if we suddenly realized that our most trusted trade partners have been slowly but inexorably imposing a tariff against U.S. goods since 2002 – a tariff now in excess of 50%.

What really stings is that these same trade partners are also our most important allies, in both military and ideological terms. We like to think we share the same moral values when it comes to defending democracy and the virtues of free market capitalism.

David Gothard How disillusioning to discover that the leading proponents of open global trade – the ones who insist on a "level playing field" – think nothing of adopting policies that render our products overly expensive for their consumers, even as they proffer their goods around the world at inordinately discounted prices.

Now you know how members of the European Union feel these days.

As former New York Fed economist David King recently observed, the value of the U.S. dollar against the euro has fallen drastically in the last few years. In December 2002, one dollar was equal in value to one euro; today, it requires more than half again as many dollars to equal one euro. For American consumers, that means prices of imported European goods are more than half again higher than they would be had the dollar retained its value relative to the euro.

Too bad for our esteemed friends across the Atlantic. If the steep price rise was the result of a tariff imposed by the U.S. government, they could haul us before the World Trade Organization on a complaint that we engage in unfair trade practices. But since it's accomplished through loose monetary policy for domestic purposes and bolstered by plausible deniability at the highest levels – "A strong dollar is in our nation's interest" – there is little the Europeans can do about it.

The euro is the official currency used by 320 million Europeans in 15 member states: Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia and Spain. Another three member states – Denmark, Sweden and the United Kingdom – use their own currencies. But the nine countries that have become EU member states since 2004 have all set convergence goals to join the eurozone in the near future: Slovakia (2009), Lithuania (2010), Estonia (2011), Bulgaria (2012), Hungary (2012), Latvia (2012), Czech Republic (2012), Poland (2012) and Romania (2012).

Taking note of these latest EU member states – former victims of Soviet-style central planning, now advocates for private enterprise – makes it clear that the U.S. has much more at stake than merely undercutting the competition in global markets with cheapened dollars. The connection between price stability and entrepreneurial effort is profound. Why should anyone work hard or take risks if financial rewards can be blithely confiscated through inflation? The old communist aphorism – "They pretend to pay us and we pretend to work" – reflects deep cynicism borne of citizen subservience to totalitarian government. Honest money is the bedrock of democratic capitalism.

When the U.S. turns a blind eye to the consequences of diluting the value of its monetary unit, when we abuse the privilege of supplying the global reserve currency by resorting to sleight-of-hand monetary policy to address our own economic problems – inflating our way out of the housing crisis, pushing taxpayers into higher brackets through stealth – it sends a disturbing message to the world.

Why would the nation that espouses Adam Smith and the wisdom of the invisible hand permit its currency to confound the validity of price signals in the global marketplace? How can Americans champion the cause of free trade and exhort other nations to rid themselves of protectionist measures such as tariffs and subsidies – and then smugly claim that U.S. exports are becoming "more competitive" as the dollar sinks?

That's not competing. It's cheating.

The U.S. cannot go on pretending the dollar's fate is somehow beyond our ken. Maintaining a reliable currency is a moral responsibility as well as a strategic imperative. To the extent we force Europeans to bear the costs of fighting inflation unleashed by accommodative Fed policy – higher interest rates and the hidden tariff of currency appreciation – we renege on our shared commitment to democratic capitalism, both in principle and practice. Moreover, we risk causing a rift in our vital alliance at a time when the geopolitical situation most requires strategic partnership.

It is interesting that one of the major foreign policy goals envisioned by Republican presidential candidate John McCain is to form a "League of Democracies" to promote the values of freedom and democracy. "I am an idealist," Sen. McCain noted in remarks before the Los Angeles World Affairs Council this past March, "and I believe it is possible in our time to make the world we live in another, better, more peaceful place, where our interests and those of our allies are more secure, and American ideals that are transforming the world, the principles of free people and free markets, advance even farther than they have."

The greatest ideological struggle since World War II – the one with the potential to devastate mankind through a nuclear exchange – united the U.S. and what was then called "Western Europe" against an "Eastern bloc" dominated by the Soviet Union. As today's Russia displays renewed interest in recapturing old territory, the seeming Cold War victory of democratic capitalism cannot be taken for granted. Nor should we underestimate the role of stable international monetary relations to facilitate free markets and secure the blessings of free trade.

Ukraine is among the most besieged – and perhaps the most pivotal – of Europe's recent converts to democracy. The biggest threat to Ukraine's prospects for success, both politically and economically? Inflation, now soaring past 30%. Ukraine's hryvnia is pegged to the dollar; every cut in the U.S. fed-funds rate spawns huge dollar inflows that must be converted by Ukraine's central bank into the domestic currency, further exacerbating inflation.

One way to mitigate the impact would be to let the hryvnia appreciate relative to the dollar. But that would doom Ukraine's efforts to boost its two main exporting industries, metallurgy and chemicals. Ironically, Russia finds itself in a similar monetary predicament, forced to choose between inflation (the ruble is based 55% on the dollar, 45% on the euro) or a rising currency.

It's hard to elicit sympathy for oil-rich Russia right now. Still, the economic uncertainties and social tensions unleashed by currency chaos can only damage the outlook for democratic states across Europe and the world. Mr. McCain's proposal for creating new institutions to secure and advance the transforming values of individual liberty and entrepreneurial capitalism holds out great promise. But to provide a stable foundation for global prosperity, the League of Democracies also needs to take on the essential task of international monetary reform.

Edouard Balladur, France's former prime minister, called for a union between Europe and the U.S. in a 120-page essay published in France last November, asserting it is time "to put an end to the disorder of floating currencies, which threatens the prosperity of the world and its progress, and which, in the end will destroy the very idea of liberalism." Nobel laureate Robert Mundell suggests a multiple-currency monetary union among the dollar, euro and yen that could be patterned similarly to the process that brought about European monetary union. Both men have invoked the possible inclusion of gold in a reformed international monetary system, recognizing the importance of protecting its integrity through automatic mechanisms and sanctions beyond the control of governments.

Notwithstanding Fed Chairman Ben Bernanke's assurances – "We are attentive to the implications of changes in the value of the dollar for inflation" – the need for honest money remains.

Imagine how Americans would feel if we suddenly realized that our most trusted trade partners have been slowly but inexorably imposing a tariff against U.S. goods since 2002 – a tariff now in excess of 50%.

What really stings is that these same trade partners are also our most important allies, in both military and ideological terms. We like to think we share the same moral values when it comes to defending democracy and the virtues of free market capitalism.

David Gothard How disillusioning to discover that the leading proponents of open global trade – the ones who insist on a "level playing field" – think nothing of adopting policies that render our products overly expensive for their consumers, even as they proffer their goods around the world at inordinately discounted prices.

Now you know how members of the European Union feel these days.

As former New York Fed economist David King recently observed, the value of the U.S. dollar against the euro has fallen drastically in the last few years. In December 2002, one dollar was equal in value to one euro; today, it requires more than half again as many dollars to equal one euro. For American consumers, that means prices of imported European goods are more than half again higher than they would be had the dollar retained its value relative to the euro.

Too bad for our esteemed friends across the Atlantic. If the steep price rise was the result of a tariff imposed by the U.S. government, they could haul us before the World Trade Organization on a complaint that we engage in unfair trade practices. But since it's accomplished through loose monetary policy for domestic purposes and bolstered by plausible deniability at the highest levels – "A strong dollar is in our nation's interest" – there is little the Europeans can do about it.

The euro is the official currency used by 320 million Europeans in 15 member states: Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia and Spain. Another three member states – Denmark, Sweden and the United Kingdom – use their own currencies. But the nine countries that have become EU member states since 2004 have all set convergence goals to join the eurozone in the near future: Slovakia (2009), Lithuania (2010), Estonia (2011), Bulgaria (2012), Hungary (2012), Latvia (2012), Czech Republic (2012), Poland (2012) and Romania (2012).

Taking note of these latest EU member states – former victims of Soviet-style central planning, now advocates for private enterprise – makes it clear that the U.S. has much more at stake than merely undercutting the competition in global markets with cheapened dollars. The connection between price stability and entrepreneurial effort is profound. Why should anyone work hard or take risks if financial rewards can be blithely confiscated through inflation? The old communist aphorism – "They pretend to pay us and we pretend to work" – reflects deep cynicism borne of citizen subservience to totalitarian government. Honest money is the bedrock of democratic capitalism.

When the U.S. turns a blind eye to the consequences of diluting the value of its monetary unit, when we abuse the privilege of supplying the global reserve currency by resorting to sleight-of-hand monetary policy to address our own economic problems – inflating our way out of the housing crisis, pushing taxpayers into higher brackets through stealth – it sends a disturbing message to the world.

Why would the nation that espouses Adam Smith and the wisdom of the invisible hand permit its currency to confound the validity of price signals in the global marketplace? How can Americans champion the cause of free trade and exhort other nations to rid themselves of protectionist measures such as tariffs and subsidies – and then smugly claim that U.S. exports are becoming "more competitive" as the dollar sinks?

That's not competing. It's cheating.

The U.S. cannot go on pretending the dollar's fate is somehow beyond our ken. Maintaining a reliable currency is a moral responsibility as well as a strategic imperative. To the extent we force Europeans to bear the costs of fighting inflation unleashed by accommodative Fed policy – higher interest rates and the hidden tariff of currency appreciation – we renege on our shared commitment to democratic capitalism, both in principle and practice. Moreover, we risk causing a rift in our vital alliance at a time when the geopolitical situation most requires strategic partnership.

It is interesting that one of the major foreign policy goals envisioned by Republican presidential candidate John McCain is to form a "League of Democracies" to promote the values of freedom and democracy. "I am an idealist," Sen. McCain noted in remarks before the Los Angeles World Affairs Council this past March, "and I believe it is possible in our time to make the world we live in another, better, more peaceful place, where our interests and those of our allies are more secure, and American ideals that are transforming the world, the principles of free people and free markets, advance even farther than they have."

The greatest ideological struggle since World War II – the one with the potential to devastate mankind through a nuclear exchange – united the U.S. and what was then called "Western Europe" against an "Eastern bloc" dominated by the Soviet Union. As today's Russia displays renewed interest in recapturing old territory, the seeming Cold War victory of democratic capitalism cannot be taken for granted. Nor should we underestimate the role of stable international monetary relations to facilitate free markets and secure the blessings of free trade.

Ukraine is among the most besieged – and perhaps the most pivotal – of Europe's recent converts to democracy. The biggest threat to Ukraine's prospects for success, both politically and economically? Inflation, now soaring past 30%. Ukraine's hryvnia is pegged to the dollar; every cut in the U.S. fed-funds rate spawns huge dollar inflows that must be converted by Ukraine's central bank into the domestic currency, further exacerbating inflation.

One way to mitigate the impact would be to let the hryvnia appreciate relative to the dollar. But that would doom Ukraine's efforts to boost its two main exporting industries, metallurgy and chemicals. Ironically, Russia finds itself in a similar monetary predicament, forced to choose between inflation (the ruble is based 55% on the dollar, 45% on the euro) or a rising currency.

It's hard to elicit sympathy for oil-rich Russia right now. Still, the economic uncertainties and social tensions unleashed by currency chaos can only damage the outlook for democratic states across Europe and the world. Mr. McCain's proposal for creating new institutions to secure and advance the transforming values of individual liberty and entrepreneurial capitalism holds out great promise. But to provide a stable foundation for global prosperity, the League of Democracies also needs to take on the essential task of international monetary reform.

Edouard Balladur, France's former prime minister, called for a union between Europe and the U.S. in a 120-page essay published in France last November, asserting it is time "to put an end to the disorder of floating currencies, which threatens the prosperity of the world and its progress, and which, in the end will destroy the very idea of liberalism." Nobel laureate Robert Mundell suggests a multiple-currency monetary union among the dollar, euro and yen that could be patterned similarly to the process that brought about European monetary union. Both men have invoked the possible inclusion of gold in a reformed international monetary system, recognizing the importance of protecting its integrity through automatic mechanisms and sanctions beyond the control of governments.

Notwithstanding Fed Chairman Ben Bernanke's assurances – "We are attentive to the implications of changes in the value of the dollar for inflation" – the need for honest money remains.

I'm not sure how well this will print here, but anything by Brian Wesbury, an absolutely outstanding supply side economist (and market prognosticator) is worth the reading:

WSJ

Change We Can Believe In Is All Around UsBy BRIAN WESBURY June 11, 2008; Page A23

Rarely do senators become president, but in less than five months either John McCain or Barack Obama will become the 44th president of the United States. That's change, and that's interesting.

It's also what everyone seems to want – change. Sen. Obama promises to provide "Change We Can Believe In." Sen. McCain suggests that "the choice is between the right change and the wrong change." If it's the war that is the focus of all this talk about change, well, that's understandable, and maybe people really do want change. But if it's the economy, it's hard to imagine that change could happen any faster.

In fact, the U.S. economy (really, the global economy) is transforming at an absolutely astounding rate. We're living in Internet Time, where policies and their consequences travel the world at the speed of light. The normal human reaction to such a rapid pace of change is to be overwhelmed, stressed out, anxious and fearful. As a result, it is probably true that when voters listen to talk about change, what they really hear are promises of "no change," which would be a huge difference from the status quo. They just want things "the way they were."

Look at the chart nearby. America's manufacturing output, as measured by the Federal Reserve, is up seven-fold since 1950, but manufacturing jobs as a share of all jobs have fallen to 10% from 30%. Your grandfather and father may have worked for General Motors (and joined the UAW), but it's likely that you don't and won't.

The problem, if it really is one, is not foreign competition or evil financiers. It is technology and productivity. In the 10 years ending in 2007, durable goods manufacturing productivity averaged an annual growth rate of 4.8%. In other words, if real growth is less than 4.8%, the sector needs fewer workers year after year.

For the economy as a whole, overall U.S. business productivity rose 2.7% at an average annual rate during the decade ending in 2007, 1.7% in the decade ending in 1997 and 1.4% in the 10 years through 1987. Change is everywhere, and it's accelerating.

This has happened before – in the Industrial Revolution – where the political environment bred America's first real populists, people like William Jennings Bryan and Theodore Roosevelt. Bryan was perhaps the best orator of American political history, and like Mr. Obama, he could affect people emotionally. Roosevelt, like Mr. McCain today, was a true American hero and one tough guy. History may not be exactly repetitive, but it sure seems to move to similar rhythms.

Unfortunately for the American economy, the populist movement of the late 19th and early 20th centuries led to a rapid growth in government intrusion into business activity. The populists didn't like the gold standard and demanded more government regulation.

AP Sens. John McCain and Barack Obama in January 2007. In 1913, the Federal Reserve System was created and the income tax was introduced to pay for a growing government. And then, during the Great Depression – which was caused by the new Fed, trade protectionism and tax rate increases – a massive expansion in government took place. Forty years later, in the malaise of the late 1970s and early 1980s, the U.S. finally figured out what it was doing wrong. By returning to hard money under Paul Volcker, and lower taxes and less regulation under Ronald Reagan, the high-tech leg of the Industrial Revolution began.

The fruits of this are plain to see. Rather than watching the sun set on the U.S., as many believed would happen in the early 1980s, the U.S. has experienced one of the greatest booms in wealth creation in world history. And the impact of our technological innovation has helped lift untold numbers out of poverty.

This technology has created massive amounts of change. Like the Industrial Revolution before it, the current transformation is anything but pain-free. It's what Joseph Schumpeter called creative destruction. Google, Craigslist and Microsoft have been prospering. General Motors, United Airlines and the New York Times have not. In the midst of layoffs in the newsroom, it's hard to see anything good happening in the rest of the economy.

Yes, there are serious problems in the housing market, and yes, oil prices are at all-time highs, even after adjusting for inflation. As a result, it feels like things are getting worse rapidly. But the subprime mess will end up costing much less in real terms than the savings-and-loan crisis. Americans are spending about 7% of their total budget on energy, roughly the same as in 1970 and well below the peak of 9% in 1981. Once the Fed starts to lift rates again, oil prices should drop.

Americans have had it so good, for so long, that they seem to have forgotten what government's heavy hand does to living standards and economic growth. But the same technological innovation that is causing all this dislocation and anxiety has also created an information network that is as near to real-time as the world has ever experienced.

For example, President Bush put steel tariffs in place in March 2002. Less than two years later, in December 2003, he rescinded them. This is something most politicians don't do. But because the tariffs caused such a sharp rise in the price of steel, small and mid-size businesses complained loudly. The unintended consequences became visible to most American's very quickly.

Decades ago the feedback mechanism was slow. The unintended consequences of the New Deal took too long to show up in the economy. As a result, by the time the pain was publicized, the connection to misguided government policy could not be made. Today, in the midst of Internet Time, this is no longer a problem. So, despite protestations from staff at the White House, most people understand that food riots in foreign lands and higher prices at U.S. grocery stores are linked to ethanol subsidies in the U.S., which have sent shock waves through the global system.

This is the good news. Policy mistakes will be ferreted out very quickly. As a result, any politician who attempts to change things will be blamed for the unintended consequences right away.

Both Mr. McCain and Mr. Obama view the world from a legislative perspective. Like the populists before them, they seem to believe that government can fix problems in the economy. They seem to believe that what the world needs is a change in the way government attacks problems and fixes the anxiety of voters. This command-and-control approach, however, forces a misallocation of resources. And in Internet Time this will become visible in almost real-time, creating real political pain for the new president.

In contrast to what some people seem to believe, having the government take over the health-care system is not change. It's just a culmination of previous moves by government. And the areas with the worst problems today are areas that have the most government interference – education, health care and energy.

The best course of action is to allow a free-market economy to reallocate resources to the place of highest returns. In the midst of all the natural change, the last thing the U.S. economy needs is more government involvement, whether it's called change or not.

Bernanke's Market WeekJune 21, 2008; Page A8The Federal Reserve's Open Market Committee meets again next week, and one of its jobs will be to clean up the mess the Fed made this week.

Earlier this month, Chairman Ben Bernanke signaled a turn in Fed policy to include a focus on maintaining a "stable" dollar. Sure enough, the dollar strengthened, the price of oil fell and stocks crept up. Then earlier this week, someone in the upper reaches of the Fed began leaking to the press in advance of next week's FOMC meeting that Mr. Bernanke saw no reason to raise interest rates this month, or indeed until the autumn.

Sure enough, oil shot up and gold rose back above $900 an ounce, with equities tanking in turn on stagflation fears. Throw in renewed worries over credit problems in the banking system, and the markets had a very ugly week.

What we can't figure out is what in the world Fed officials are thinking, assuming that's even the right word. The most precious commodity a Fed Chairman has is credibility. When he makes a widely advertised public commitment to maintain dollar stability, and then he or his minions leak that he has no plans to back that up with any action, he is squandering his own currency. Central banking isn't an academic seminar where ideas don't have consequences.

With inflation climbing around the globe, most of it inspired by dollar weakness, the Fed has a growing credibility problem. Mr. Bernanke needs to understand that investors are beginning to suspect that the most important financial official in the world doesn't seem to appreciate the Fed's primary role in undermining the greenback. If that conclusion becomes fixed, this week's market meltdown will look pretty by comparison.

When John McCain met privately with Rep. Paul Ryan of Wisconsin after a political event in the Milwaukee suburbs May 29, the Republican presidential candidate might not have realized that he had just come face to face with an opportunity and a test. Ryan showed him his plan to reform the economy. McCain expressed interest and said he would turn it over to his campaign's economists.

That was truly ominous. If the Kemp-Roth tax cut had been handed over to economists three decades ago, it likely would have died in its crib and aborted the national and Republican revival under President Ronald Reagan. Ryan's plan is more sweeping than the proposal by his boss and mentor Jack Kemp, who dealt only with taxes. In 70 pages, "Ryan's Roadmap for America's Future" shows the way to reform taxes, control spending and brake runaway entitlement outlays.

Ryan has proposed far too much to handle for nervous House Republican leaders. They have refrained from publicly knocking Ryan down only because they are in a state of terror over their party's desperate condition, as indicated by plummeting polls and special election defeats. More important is the yet unstated reaction by McCain, famously uninterested in economics but never shy on courage to defy the conventional wisdom.

Actually, to embrace Ryan's Roadmap requires more political insight than courage. Ryan was met with enthusiastic approval at some 35 town meetings in his southern Wisconsin industrial district, where he unveiled his plan over the last two months. His constituents, who sent liberal Democrat Les Aspin to Congress for 22 years, are legendary "Reagan Democrats" who have soured on the GOP. Ryan believes they are far ahead of politicians in their alarm over entitlements. "Do we have the guts to act?" asks Ryan.Continued

Ryan fears potential national disaster is ahead because we "will exceed the European extent of government and bring our economy to extinction." With the U.S. government share of the economy at 20 percent, he sees it rising to a calamitous 40 percent when his three children (ages 3, 4 and 6) reach their 30s, requiring a doubled tax rate. President Bush's appropriations rose $49 billion over the last year, and the Democratic-controlled House upped that ante. But spending enacted by Congress is dwarfed by statutory increases in Social Security, Medicare, Medicaid and other entitlements.

But his boldest thrust comes in radical changes to entitlements, including an option for persons under 55 years old to buy private retirement insurance, plus reduced benefits and delayed retirement for Social Security. His Internal Revenue reform would amount to an optional modified flat tax (advocated in principle by McCain) and substituting a small business consumption tax for the corporate income tax rate -- while holding federal taxes to 18.5 percent of gross domestic product.

It is hardly likely the Republican leadership would embrace Ryan's daring agenda if it cannot even bring itself temporarily to forego pork-barrel spending by passing a moratorium on earmarks. But Ryan represents a younger breed of reform Republicans who now have junior leadership positions.

Ryan, 38, top Republican on the House Budget Committee, has been working closely with freshman Rep. Kevin McCarthy, 43, who has been named chairman of the national platform by Minority Leader John Boehner, and Rep. Eric Cantor of Virginia, 45, the party's chief deputy whip. After another expected bad GOP defeat in the 2008 congressional elections, Ryan, McCarthy and Cantor could constitute the party's new House leadership.

But who will be in the White House? McCain so far has generated little excitement in his own Republican base, much less among Reagan Democrats. His cautious political and economic advisers flinch at complicated tax changes, massive budget cuts and tampering with Social Security. But a campaign based on Barack Obama's shortcomings may not be enough on Election Day. While Ryan says the people are more than ready for his strong medicine, McCain has not yet agreed.

Secretary of Labor Elaine L. Chao immigrated to the United States on a cargo ship in 1961, when she was 8 years old. The trip from Taiwan took a month. It was no easy passage.

"My sister fell ill during the ocean journey," she told me on a recent afternoon in her spacious office, a short walk from the U.S. Capitol. "Seventeen hundred nautical miles, there were no doctors on board and my mother sat up for three nights and three days, just continuously soaking my sister's body, little body, with cold water" to break her fever.

Zina Saunders "So I see opportunities in this country, perhaps, in a slightly different way. . . . America really is unique," she says. "It's really a land of meritocracy, where it doesn't matter where you were born, who you know. If a person works hard, most of the time . . ."

On this last point, Ms. Chao's words trail off, as the current state of the economy seems to be weighing on her mind. There is widespread speculation that the economy could soon slip into recession as the country sheds jobs and faces a slumping housing market. Still, Ms. Chao points out that the national unemployment rate remains below where it averaged in the 1990s (5.5% today versus 5.7% last decade). "People forget that," she says.

Yet Ms. Chao seems most concerned with the long-term trends that affect the workforce. The old economy that relied heavily on domestic manufacturing and production is giving way to a modern economy based on technology and instant communications. This change is empowering workers, allowing them to work more flexible schedules and boost their productivity. At the same time, it is also changing the criteria required to get ahead -- and forcing a decline in union membership.

In 1979, 24.1% of American workers belonged to a union. Today only 12.1% do, and the number falls to 7.5% for those who do not work for the government. Whether a worker has a college or even a high-school diploma is now much more important for lifetime earnings and employment than whether they have a union card.

Numbers tell the story. Workers with a bachelor's degree earn, on average, more than $1,400 a week and have an unemployment rate of just 2.2%. High-school dropouts, by contrast, average just $528 a week for full-time work and their unemployment rate is 8.3%. "We have a skills gap in this country," Ms. Chao said.

Ms. Chao seems to be concerned that the country could cease to be the land of opportunity that drew her parents decades ago. Congress appears eager to impose restrictive regulations that could hurt the economy in the name of helping those who don't have the skills to compete. If these regulations are enacted, Ms. Chao fears the "Europeanization" of the American economy.

"I have a whole list here," she says, of what Congress could do to hobble economic growth, and it includes legislation that is gaining traction on Capitol Hill. Every measure would make it more expensive to employ people in America, or would make it easier for unions to capture a larger slice of the workforce.

On the list is "card check" -- legislation that would allow union leaders to dispense with secret ballot elections in unionizing a company's workforce. Instead, union officials would be allowed to get the union certified once a majority of employees in a workplace merely signed a union card. This measure -- the most radical change in labor relations since the New Deal -- passed the House last year, but was stopped in the Senate. Ms. Chao is happy it was. "The right to a private ballot election is a fundamental right in our American democracy and it should not be legislated away at the behest of special interest groups," she says.

Other items on her list include bills that would expand the Family Medical Leave Act, force some employers to give 90 days' notice before laying off workers (up from 60 days now), and mandate minimum paid sick leave. There's also "comparable worth," a bill being pushed by Sen. Hillary Clinton and others that would force employers to pay the same wages for different occupations. Employers would have to pay nursing aides (mostly female), for example, the same wages they offer janitors (mostly male), if the bureaucracy deemed these occupations were of comparable value.

If these regulations become law next year, she believes it would make it more difficult for employers to adapt their workforce to a changing economy. "The flexibility of our workforce is one of the reasons for our great economic success," she says. "Only with our flexibility will there be continued dynamism, vibrancy and opportunities. We had young people in France rioting at the age of 24 because they fear that if they do not find a job by the age of 24 that they will never find a job for the rest of their lives. That is so foreign to what the American experience is all about."

"The Eurozone countries and Japan have not created as many jobs as America has in the last seven years," she adds. "And their unemployment rate is double, if not sometimes triple, that of the United States. So the best way to help a worker get a job . . . is to help them get reconnected to the workforce as quickly as possible because the longer they stay out, the more things will change at the workplace and the harder it will be for them to re-enter the workforce."

"Some in Washington want to increase benefits, regulations and mandates and that's the European model. That is not the path we want to follow long term."

Ms. Chao says that when she attends meetings with other labor ministers from around the world, "they may not agree totally with our point of view, but they all want to learn about how America creates opportunities and jobs and how the dynamism of our economy, the flexibility of our economy creates opportunities."

What does she tell them?

"That freedom works. It is universally accepted that there needs to be open markets, transparency, low tax rates, less regulation and the rule of law . . . in a world-wide economy if there is not transparency, if there is greater taxation, if there is greater regulation, capital and labor will move."

Ms. Chao is in charge of one of the most powerful regulatory agencies in the federal government. She's also amassed a record conservatives applaud -- for example in year seven of her tenure, her department's budget is slightly smaller than it was on year one, even as workplace injuries have fallen to all time lows.

When I ask her what role a labor secretary should play now, her answer can be summed up in two words: job training.

"We should really be called the department of job training," she says. After all, the labor department spends more than 90% of its $50 billion entitlement budget on it. The problem is that much of this never reaches workers. Instead, it's wasted on overhead or spent on courses workers don't want to take.

So in her last months in office Ms. Chao is pushing for more flexibility in how job training funds can be used. "Would it not make more sense if we allowed . . . the worker to take that money and register at a community college . . . choose a course of their own liking, preference?"

An even more important issue is transparency. One of Ms. Chao's early initiatives was to clean up decades-old regulations that mired even good employers in costly litigation because the rules were written for occupations that no longer exist. "Straw boss" and "key punch" are two that Ms. Chao rattled off. "We in government have a responsibility for ensuring that the regulations that we issue are clear and understandable."

Another of Ms. Chao's transparency initiatives involved union financial disclosure. Federal union disclosure rules have been on the books since at least 1959. But when Ms. Chao came into office in 2001, many unions gave such vague descriptions of their expenses that it was impossible to track where they spent their money. One, for example, listed more than $3.9 million of expenditures as "sundry expenses."

Ms. Chao tightened the disclosure rules and then spent years fighting union objections in court. In the end she won. Today unions have to itemize expenses greater than $5,000. This has made it easier for rank-and-file members to keep tabs on their own union officials. It has also led to more than a little embarrassment, such as when a disclosure form filed by the New York City Ironworkers Local 40 in 2006 drew media attention because it revealed that the union spent $52,879 at a Cadillac dealer for a "retirement gift."

But when I ask what she thinks about being called a foe of unionized labor, she stops me before I can finish the question. "I just enforce the law." There are approximately 180 laws that the labor department is charged with administering. Her success has come by quietly enforcing all of them.

This no-nonsense approach to her job and her faith in the flexibility of America's labor markets stems from Ms. Chao's immigrants roots.

Her parents fled the communist revolution in China in 1949 and settled in Taiwan. As a sea captain nearly a decade later, her father had few economic opportunities. So he took the National Maritime Master's Special Qualification Examination and scored so well that the Taiwanese government sponsored him to study in the U.S. But there was a catch: The offer was for him alone. He would have to leave his two children and wife behind.

"They never hesitated," she said, adding that "my mother didn't try to persuade my father not to go. In fact, it was quite the opposite.

"He came and landed the day after Christmas. He was alone for three years . . . before he was finally able to bring us over."

"How they knew what America stood for, or where America was, is pretty impressive to me -- that this young couple with no connections, no financial resources to speak of, would dare to audaciously dream that they could come to America."

Mr. Miniter is an assistant features editor at The Wall Street Journal.

Washington can be counted on to create a crisis -- usually by sheer incompetence. Then it rushes to the rescue, often doing more harm than good. Late last year, with an impending recession, Congress rushed forward to spend more money. The plan was to send $106 billion of Economic Stimulus Payments -- typically between $1,200 and $1,800 -- to millions of American families.

The planners predicted people would immediately spend the money on additional consumption and that increased demand, especially for consumer durables, would stimulate production, boost the economy, and forestall recession. In January, House Speaker Nancy Pelosi declared that 500,000 jobs would be created.

FROM THE ARCHIVES

Stupidity and the State, Part I06/07/08By the end of June, $86 billion was in the hands of 105 million households. By October, the remaining $20 billion will have been shoveled out the door. But people have not gone on a spending spree. Recent Commerce Department data indicate that less than 10% of the stimulus money is being spent on new consumption.

In a classic case of government working against itself, other more powerful government actions, including the Fed's extraordinarily loose monetary policy, have boosted inflation and caused families to restrict purchases, especially in the case of higher-priced consumer durables. Overall, compared to last year, the quantity of consumer durables purchased has declined by 1.5%. Retail sales are sluggish. Contrary to Ms. Pelosi's confident prediction, the economy has shed 460,000 jobs since December.

Thanks to an increased rate of inflation compared to last year, the basic CPI market basket is now 1.6% higher than it otherwise would be. As a result, even before receiving its $1,200 stimulus check, a typical two-earner family with income of $75,000 will have already experienced a $1,200 decline in its purchasing power since last year. So much for the stimulus plan; it's been wiped out by extra inflation. Worse, the hole in the family's budget from inflation is permanent. It will be there next year and thereafter, even if the rate of increase in future inflation slows -- although many economists predict higher, not lower, rates of inflation.

On net, members of Congress seem to be the only beneficiaries of the stimulus. They got to posture and pose, and send out to voters untold millions of press releases and mailings extolling themselves and the stimulus checks.

None mentioned the government's low interest rates which touched off the housing bubble that's led to the economic turndown, or the inflation that's undermined the very expensive remedy that hasn't worked as planned. But that didn't stop Ms. Pelosi from proposing another $50 billion "stimulus" package on Thursday.

Mr. Christian, an attorney, was a deputy assistant secretary of the Treasury in the Ford administration. Mr. Robbins, an economist, served at the Treasury Department in the Reagan administration.

Angelo Mozilo was in one of his Napoleonic moods. It was October 2003, and the CEO of Countrywide Financial was berating me for The Wall Street Journal's editorials raising doubts about the accounting of Fannie Mae. I had just been introduced to him by Franklin Raines, then the CEO of Fannie, whom I had run into by chance at a reception hosted by the Business Council, the CEO group that had invited me to moderate a couple of panels.

Mr. Mozilo loudly declared that I didn't know what I was talking about, that I didn't understand accounting or the mortgage markets, and that I was in the pocket of Fannie's competitors, among other insults. Mr. Raines, always smoother than Mr. Mozilo, politely intervened to avoid an extended argument, and Countrywide's bantam rooster strutted off.

AP Clockwise from top left: Barney Frank, Franklin Raines, Mike Oxley, Angelo Mozilo and Paul Krugman. I've thought about that episode more than once recently amid the meltdown and government rescue of Fannie and its sibling, Freddie Mac. Trying to defend the mortgage giants, Paul Krugman of the New York Times recently wrote, "What you need to know here is that the right -- the WSJ editorial page, Heritage, etc. -- hates, hates, hates Fannie and Freddie. Why? Because they don't want quasi-public entities competing with Angelo Mozilo."

That's a howler even by Mr. Krugman's standards. Fannie Mae and Mr. Mozilo weren't competitors; they were partners. Fannie helped to make Countrywide as profitable as it once was by buying its mortgages in bulk. Mr. Raines -- following predecessor Jim Johnson -- and Mr. Mozilo made each other rich. Which explains why Mr. Johnson could feel so comfortable asking Sen. Kent Conrad (D., N.D.) to discuss a sweetheart mortgage with Mr. Mozilo, and also explains the Mozilo-Raines tag team in 2003.

FANNIE MAYHEM: A HISTORY

Click here for a compendium of The Wall Street Journal's recent editorial coverage of Fannie and Freddie.I recount all this now because it illustrates the perverse nature of Fannie and Freddie that has made them such a relentless and untouchable political force. Their unique clout derives from a combination of liberal ideology and private profit. Fannie has been able to purchase political immunity for decades by disguising its vast profit-making machine in the cloak of "affordable housing." To be more precise, Fan and Fred have been protected by an alliance of Capitol Hill and Wall Street, of Barney Frank and Angelo Mozilo.

I know this because for more than six years I've been one of their antagonists. Any editor worth his expense account makes enemies, and complaints from CEOs, politicians and World Bank presidents are common. But Fannie Mae and Freddie Mac are unique in their thuggery, and their response to critics may help readers appreciate why taxpayers are now explicitly on the hook to rescue companies that some of us have spent years warning about.

THE GANG RESPONDS

• Sen. Kent Conrad (D. N.D.) – 06/23/08• Rep. Michael G. Oxley (R. Ohio) – 05/11/06• Franklin Raines – 02/25/02My battles with Fan and Fred began with no great expectations. In late 2001, I got a tip that Fannie's derivatives accounting might be suspect. I asked Susan Lee to investigate, and the editorial she wrote in February 2002, "Fannie Mae Enron?", sent Fannie's shares down nearly 4% in a day. In retrospect, my only regret is the question mark.

Mr. Raines reacted with immediate fury, denouncing us in a letter to the editor as "glib, disingenuous, contorted, even irresponsible," and that was the subtle part. He turned up on CNBC to say, in essence, that we had made it all up because we didn't want poor people to own houses, while Freddie issued its own denunciation.

The companies also mobilized their Wall Street allies, who benefited both from promoting their shares and from selling their mortgage-backed securities, or MBSs. The latter is a beautiful racket, thanks to the previously implicit and now explicit government guarantee that the companies are too big to fail. The Street can hawk Fan and Fred MBSs as nearly as safe as Treasurys but with a higher yield. They make a bundle in fees.

At the time, Wall Street's Fannie apologists outdid themselves with their counterattack. One of the most slavish was Jonathan Gray, of Sanford C. Bernstein, who wrote to clients that the editorial was "unfounded and unsubstantiated" and "discredits the paper." My favorite point in his Feb. 20, 2002, Bernstein Research Call was this rebuttal to our point that "Taxpayers Are on The Hook: This is incorrect. The agencies' debt is not guaranteed by the U.S. Treasury or any agency of the Federal Government." Oops.

Mr. Gray's memo made its way to Wall Street Journal management via Michael Ellmann, a research analyst who had covered Dow Jones and was then at Grantham, Mayo, Van Otterloo & Co. "I think Gray is far more accurate than your editorial writer. Your subscribers deserve better," he wrote to one senior executive.

I also received several interventions from friends and even Dow Jones colleagues on behalf of the companies. But I was especially startled one day to find in my mail a personal letter from George Gould, an acquaintance about whom I'd written a favorable column when he was Treasury undersecretary for finance in 1988.

Mr. Gould's letter assailed our editorials and me in nasty personal terms, and I quickly discovered the root of his vitriol: Though his letter didn't say so, he had become a director of Freddie Mac. He was still on the board when Freddie's accounting lapses finally exploded into a scandal some months later.

The companies eased their assaults when they concluded we weren't about to stop, and in any case they soon had bigger problems. Freddie's accounting fiasco became public in 2003, while Fannie's accounting blew up in 2004. Mr. Raines was forced to resign, and a report by regulator James Lockhart discovered that Fannie had rigged its earnings in a way that allowed it to pay huge bonuses to Mr. Raines and other executives.

Such a debacle after so much denial would have sunk any normal financial company, but once again Fan and Fred could fall back on their political protection. In the wake of Freddie's implosion, Republican Rep. Cliff Stearns of Florida held one hearing on its accounting practices and scheduled more in early 2004.

He was soon told that not only could he hold no more hearings, but House Speaker Dennis Hastert was stripping his subcommittee of jurisdiction over Fan and Fred's accounting and giving it to Mike Oxley's Financial Services Committee. "It was because of all their lobbying work," explains Mr. Stearns today, in epic understatement. Mr. Oxley proceeded to let Barney Frank (D., Mass.), then in the minority, roll all over him and protect the companies from stronger regulatory oversight. Mr. Oxley, who has since retired, was the featured guest at no fewer than 19 Fannie-sponsored fund-raisers.

Or consider the experience of Wisconsin Rep. Paul Ryan, one of the GOP's bright young lights who decided in the 1990s that Fan and Fred needed more supervision. As he held town hall meetings in his district, he soon noticed a man in a well-tailored suit hanging out amid the John Deere caps and street clothes. Mr. Ryan was being stalked by a Fannie lobbyist monitoring his every word.

On another occasion, he was invited to a meeting with the Democratic mayor of Racine, which is in his district, though he wasn't sure why. When he arrived, Mr. Ryan discovered that both he and the mayor had been invited separately -- not by each other, but by a Fannie lobbyist who proceeded to tell them about the great things Fannie did for home ownership in Racine.

When none of that deterred Mr. Ryan, Fannie played rougher. It called every mortgage holder in his district, claiming (falsely) that Mr. Ryan wanted to raise the cost of their mortgage and asking if Fannie could tell the congressman to stop on their behalf. He received some 6,000 telegrams. When Mr. Ryan finally left Financial Services for a seat on Ways and Means, which doesn't oversee Fannie, he received a personal note from Mr. Raines congratulating him. "He meant good riddance," says Mr. Ryan.

Fan and Fred also couldn't prosper for as long as they have without the support of the political left, both in Congress and the intellectual class. This includes Mr. Frank and Sen. Chuck Schumer (D., N.Y.) on Capitol Hill, as well as Mr. Krugman and the Washington Post's Steven Pearlstein in the press. Their claim is that the companies are essential for homeownership.

Yet as studies have shown, about half of the implicit taxpayer subsidy for Fan and Fred is pocketed by shareholders and management. According to the Federal Reserve, the half that goes to homeowners adds up to a mere seven basis points on mortgages. In return for this, Fannie was able to pay no fewer than 21 of its executives more than $1 million in 2002, and in 2003 Mr. Raines pocketed more than $20 million. Fannie's left-wing defenders are underwriters of crony capitalism, not affordable housing.

So here we are this week, with the House and Senate preparing to commit taxpayer money to save Fannie and Freddie. The implicit taxpayer guarantee that Messrs. Gray and Raines and so many others said didn't exist has become explicit. Taxpayers may end up having to inject capital into the companies, in addition to guaranteeing their debt.

The abiding lesson here is what happens when you combine private profit with government power. You create political monsters that are protected both by journalists on the left and pseudo-capitalists on Wall Street, by liberal Democrats and country-club Republicans. Even now, after all of their dishonesty and failure, Fannie and Freddie could emerge from this taxpayer rescue more powerful than ever. Campaigning to spare taxpayers from that result would represent genuine "change," not that either presidential candidate seems interested.

You Know The Banking System Is Unsound When...Mike "Mish" ShedlockJul 24, 2008

1. Paulson appears on Face The Nation and says "Our banking system is a safe and a sound one." If the banking system was safe and sound, everyone would know it (or at least think it). There would be no need to say it.

2. Paulson says the list of troubled banks "is a very manageable situation". The reality is there are 90 banks on the list of problem banks. Indymac was not one of them until a month before it collapsed. How many other banks will magically appear on the list a month before they collapse?

3. In a Northern Rock moment, depositors at Indymac pull out their cash. Police had to be called in to ensure order.

4. Washington Mutual (WM), another troubled bank, refused to honor Indymac cashier's checks. The irony is it makes no sense for customers to pull insured deposits out of Indymac after it went into receivership. The second irony is the last place one would want to put those funds would be Washington Mutual. Eventually Washington Mutual decided it would take those checks but with an 8 week hold. Will Washington Mutual even be around 8 weeks from now?

5. Paulson asked for "Congressional authority to buy unlimited stakes in and lend to Fannie Mae (FNM) and Freddie Mac (FRE)" just days after he said "Financial Institutions Must Be Allowed To Fail". Obviously Paulson is reporting from the 5th dimension. In some alternate universe, his statements just might make sense.

7. Paulson says Fannie Mae and Freddie Mac are "essential" because they represent the only "functioning" part of the home loan market. The firms own or guarantee about half of the $12 trillion in U.S. mortgages. Is it possible to have a sound banking system when the only "functioning" part of the mortgage market is insolvent?

8. Bernanke testified before Congress on monetary policy but did not comment on either money supply or interest rates. The word "money" did not appear at all in his testimony. The only time "interest rate" appeared in his testimony was in relation to consumer credit card rates. How can you have any reasonable economic policy when the Fed chairman is scared half to death to discuss interest rates and money supply?

9. The SEC issued a protective order to protect those most responsible for naked short selling. As long as the investment banks and brokers were making money engaging in naked shorting of stocks, there was no problem. However, when the bears began using the tactic against the big financials, it became time to selectively enforce the existing regulation.

10. The Fed takes emergency actions twice during options expirations week in regards to the discount window and rate cuts.

12. The Fed has implemented an alphabet soup of pawn shop lending facilities whereby the Fed accepts garbage as collateral in exchange for treasuries. Those new Fed lending facilities are called the Term Auction Facility (TAF), the Term Security Lending Facility (TSLF), and the Primary Dealer Credit Facility (PDCF).

13. Citigroup (C), Lehman (LEH), Morgan Stanley(MS), Goldman Sachs (GS) and Merrill Lynch (MER) all have a huge percentage of level 3 assets. Level 3 assets are commonly known as "marked to fantasy" assets. In other words, the value of those assets is significantly if not ridiculously overvalued in comparison to what those assets would fetch on the open market. It is debatable if any of the above firms survive in their present form. Some may not survive in any form.

14. Bernanke openly solicits private equity firms to invest in banks. Is this even close to a remotely normal action for Fed chairman to take?

15. Bear Stearns was taken over by JPMorgan (JPM) days after insuring investors it had plenty of capital. Fears are high that Lehman will suffer the same fate. Worse yet, the Fed had to guarantee the shotgun marriage between Bear Stearns and JP Morgan by providing as much as $30 billion in capital. JPMorgan is responsible for only the first 1/2 billion. Taxpayers are on the hook for all the rest. Was this a legal action for the Fed to take? Does the Fed care?

16. Citigroup needed a cash injection from Abu Dhabi and a second one elsewhere. Then after announcing it would not need more capital is raising still more. The latest news is Citigroup will sell $500 billion in assets. To who? At what price?

17. Merrill Lynch raised $6.6 billion in capital from Kuwait Mizuho, announced it did not need to raise more capital, then raised more capital a few week later.

18. Morgan Stanley sold a 9.9% equity stake to China International Corp. CEO John Mack compensated by not taking his bonus. How generous. Morgan Stanley fell from $72 to $37. Did CEO John Mack deserve a paycheck at all?

19. Bank of America (BAC) agreed to take over Countywide Financial (CFC) and twice announced Countrywide will add profits to B of A. Inquiring minds were asking "How the hell can Countrywide add to Bank of America earnings?" Here's how. Bank of America just announced it will not guarantee $38.1 billion in Countrywide debt. Questions over "Fraudulent Conveyance" are now surfacing.

20. Washington Mutual agreed to a death spiral cash infusion of $7 billion accepting an offer at $8.75 when the stock was over $13 at the time. Washington Mutual has since fallen in waterfall fashion from $40 and is now trading near $5.00 after a huge rally.

21. Shares of Ambac (ABK) fell from $90 to $2.50. Shares of MBIA (MBI) fell from $70 to $5. Sadly, the top three rating agencies kept their rating on the pair at AAA nearly all the way down. No one can believe anything the government sponsored rating agencies say.

22. In a panic set of moves, the Fed slashed interest rates from 5.25% to 2%. This was the fastest, steepest drop on record. Ironically, the Fed chairman spoke of inflation concerns the entire drop down. Bernanke clearly cannot tell the truth. He does not have to. Actions speak louder than words.

23. FDIC Chairman Sheila Bair said the FDIC is looking for ways to shore up its depleted deposit fund, including charging higher premiums on riskier brokered deposits.

24. There is roughly $6.84 Trillion in bank deposits. $2.60 Trillion of that is uninsured. There is only $53 billion in FDIC insurance to cover $6.84 Trillion in bank deposits. Indymac will eat up roughly $8 billion of that.

25. Of the $6.84 Trillion in bank deposits, the total cash on hand at banks is a mere $273.7 Billion. Where is the rest of the loot? The answer is in off balance sheet SIVs, imploding commercial real estate deals, Alt-A liar loans, Fannie Mae and Freddie Mac bonds, toggle bonds where debt is amazingly paid back with more debt, and all sorts of other silly (and arguably fraudulent) financial wizardry schemes that have bank and brokerage firms leveraged at 30-1 or more. Those loans cannot be paid back.

What cannot be paid back will be defaulted on. If you did not know it before, you do now. The entire US banking system is insolvent.

What if I told you that a prominent global political figure in recent months has proposed: abrogating key features of his government's contracts with energy companies; unilaterally renegotiating his country's international economic treaties; dramatically raising marginal tax rates on the "rich" to levels not seen in his country in three decades (which would make them among the highest in the world); and changing his country's social insurance system into explicit welfare by severing the link between taxes and benefits?

AP The first name that came to mind would probably not be Barack Obama, possibly our nation's next president. Yet despite his obvious general intelligence, and uplifting and motivational eloquence, Sen. Obama reveals this startling economic illiteracy in his policy proposals and economic pronouncements. From the property rights and rule of (contract) law foundations of a successful market economy to the specifics of tax, spending, energy, regulatory and trade policy, if the proposals espoused by candidate Obama ever became law, the American economy would suffer a serious setback.

To be sure, Mr. Obama has been clouding these positions as he heads into the general election and, once elected, presidents sometimes see the world differently than when they are running. Some cite Bill Clinton's move to the economic policy center following his Hillary health-care and 1994 Congressional election debacles as a possible Obama model. But candidate Obama starts much further left on spending, taxes, trade and regulation than candidate Clinton. A move as large as Mr. Clinton's toward the center would still leave Mr. Obama on the economic left.

Also, by 1995 the country had a Republican Congress to limit President Clinton's big government agenda, whereas most political pundits predict strengthened Democratic majorities in both Houses in 2009. Because newly elected presidents usually try to implement the policies they campaigned on, Mr. Obama's proposals are worth exploring in some depth. I'll discuss taxes and trade, although the story on his other proposals is similar.

First, taxes. The table nearby demonstrates what could happen to marginal tax rates in an Obama administration. Mr. Obama would raise the top marginal rates on earnings, dividends and capital gains passed in 2001 and 2003, and phase out itemized deductions for high income taxpayers. He would uncap Social Security taxes, which currently are levied on the first $102,000 of earnings. The result is a remarkable reduction in work incentives for our most economically productive citizens.

The top 35% marginal income tax rate rises to 39.6%; adding the state income tax, the Medicare tax, the effect of the deduction phase-out and Mr. Obama's new Social Security tax (of up to 12.4%) increases the total combined marginal tax rate on additional labor earnings (or small business income) from 44.6% to a whopping 62.8%. People respond to what they get to keep after tax, which the Obama plan reduces from 55.4 cents on the dollar to 37.2 cents -- a reduction of one-third in the after-tax wage!

Despite the rhetoric, that's not just on "rich" individuals. It's also on a lot of small businesses and two-earner middle-aged middle-class couples in their peak earnings years in high cost-of-living areas. (His large increase in energy taxes, not documented here, would disproportionately harm low-income Americans. And, while he says he will not raise taxes on the middle class, he'll need many more tax hikes to pay for his big increase in spending.)

On dividends the story is about as bad, with rates rising from 50.4% to 65.6%, and after-tax returns falling over 30%. Even a small response of work and investment to these lower returns means such tax rates, sooner or later, would seriously damage the economy.

On economic policy, the president proposes and Congress disposes, so presidents often wind up getting the favorite policy of powerful senators or congressmen. Thus, while Mr. Obama also proposes an alternative minimum tax (AMT) patch, he could instead wind up with the permanent abolition plan for the AMT proposed by the Ways and Means Committee Chairman Charlie Rangel (D., N.Y.) -- a 4.6% additional hike in the marginal rate with no deductibility of state income taxes. Marginal tax rates would then approach 70%, levels not seen since the 1970s and among the highest in the world. The after-tax return to work -- the take-home wage for more time or effort -- would be cut by more than 40%.

Now trade. In the primaries, Sen. Obama was famously protectionist, claiming he would rip up and renegotiate the North American Free Trade Agreement (Nafta). Since its passage (for which former President Bill Clinton ran a brave anchor leg, given opposition to trade liberalization in his party), Nafta has risen to almost mythological proportions as a metaphor for the alleged harm done by trade, globalization and the pace of technological change.

Yet since Nafta was passed (relative to the comparable period before passage), U.S. manufacturing output grew more rapidly and reached an all-time high last year; the average unemployment rate declined as employment grew 24%; real hourly compensation in the business sector grew twice as fast as before; agricultural exports destined for Canada and Mexico have grown substantially and trade among the three nations has tripled; Mexican wages have risen each year since the peso crisis of 1994; and the two binational Nafta environmental institutions have provided nearly $1 billion for 135 environmental infrastructure projects along the U.S.-Mexico border.

In short, it would be hard, on balance, for any objective person to argue that Nafta has injured the U.S. economy, reduced U.S. wages, destroyed American manufacturing, harmed our agriculture, damaged Mexican labor, failed to expand trade, or worsened the border environment. But perhaps I am not objective, since Nafta originated in meetings James Baker and I had early in the Bush 41 administration with Pepe Cordoba, chief of staff to Mexico's President Carlos Salinas.

Mr. Obama has also opposed other important free-trade agreements, including those with Colombia, South Korea and Central America. He has spoken eloquently about America's responsibility to help alleviate global poverty -- even to the point of saying it would help defeat terrorism -- but he has yet to endorse, let alone forcefully advocate, the single most potent policy for doing so: a successful completion of the Doha round of global trade liberalization. Worse yet, he wants to put restrictions into trade treaties that would damage the ability of poor countries to compete. And he seems to see no inconsistency in his desire to improve America's standing in the eyes of the rest of the world and turning his back on more than six decades of bipartisan American presidential leadership on global trade expansion. When trade rules are not being improved, nontariff barriers develop to offset the liberalization from the current rules. So no trade liberalization means creeping protectionism.

History teaches us that high taxes and protectionism are not conducive to a thriving economy, the extreme case being the higher taxes and tariffs that deepened the Great Depression. While such a policy mix would be a real change, as philosophers remind us, change is not always progress.

Mr. Boskin, professor of economics at Stanford University and senior fellow at the Hoover Institution, was chairman of the Council of Economic Advisers under President George H.W. Bush.

Our housing finance system has been broken for quite some time, creating perverse incentives for borrowers and lenders. We have now reaped the consequences, and a major financial bailout of the system is probably inevitable.

Conservatives can rightly argue that had Congressional Democrats not blocked the various initiatives of the Bush administration to reform Fannie Mae and Freddie Mac for the past five years, we would not be sitting at the precipice like we are today. But that does not change the need for a government injection of funds to fill the financial hole in those two enterprises. The institutional arrangements in the American mortgage market cannot be changed overnight, and the risks of a breakdown in that market at some point over the next 18 months are still quite real.

Chad Crowe The trouble is, the legislation that just passed Congress indicates that Washington has learned nothing from our recent troubles. And, as this bailout bill is likely to be followed by at least one additional bill next year, the evident inability or unwillingness of Congress to move up the learning curve and abandon its past practices will make the ultimate cost to the taxpayer far higher than it might have been.

The 700 pages of legislation, which I doubt many members of Congress have even attempted to read, contains many egregious provisions, some of which are unrelated to the trouble at hand. But the pork designed to buy votes for the legislation pales before the blunders directly related to the problem at hand.

First, Congress rejected a proposal that Fannie and Freddie be barred from paying dividends if they are receiving injections of capital from the federal government. This idea would seem to be the first lesson in a course on Government Bailout 101. The government shouldn't be shoveling taxpayer money in the front door while the company is shoveling dividends to shareholders out the back door.

Freddie Mac paid $1.6 billion in dividends last year while Fannie Mae paid $2.5 billion. Both have dividend yields that are many times higher than the norm. Congress chose to protect the shareholders at the expense of the taxpayer.

Second, Congress did not give the taxpayer any of the upside from a potential recovery of Fannie and Freddie, leaving it all with existing management and existing shareholders. This breaks with past bailout or workout traditions in both the public sector and the private sector. In the Chrysler bailout of the 1980s, the government gave itself warrants that paid off when the company recovered. In most private-sector deals, existing common shareholders get virtually wiped out (Bear Stearns, for example) while preferred shareholders at least get a haircut. Fannie and Freddie shareholders were untouched by this bill. Congress bailed them out on the downside and preserved their upside potential.

Third, the legislation did not produce any substantive reforms in the home-lending area, particularly the problems which became endemic in the recent bubble. For example, President Bush asked for authority to allow for risk-based pricing in government-generated mortgages. That idea is based on the commonsense view that higher-risk customers should pay higher interest rates.

Congress rejected this, despite the lessons of the recent housing boom and bust associated with risky lending. And when it came to controlling risk through minimum down payments by homebuyers, the legislation set the required down payment for a government mortgage at only 3½%.

Fourth, the legislation included a special tax on mortgages originated by Fannie and Freddie to go into a fund for "affordable housing" run by politicians and community activists. It may seem natural for politicians to help out their colleagues and the people who turn out the votes on election day with newly dedicated taxes. But whatever logic there is in boosting taxes on entities that need public funds escapes me.

The list of such nonsensical provisions goes on and on. The examples mentioned above were not surprises snuck into the legislation in the dark of night. The president threatened to veto the bill in a formal Statement of Administration Policy issued on July 11 because it contained such objectionable items. The veto threat was reiterated by the White House just days before the House passed the legislation, but Treasury Secretary Henry Paulson reversed the veto threat in time for the vote.

The usual reason given for monstrosities such as this is that these provisions were needed to secure passage and that the need to pass the bill was pressing. But was it really that pressing? Fannie and Freddie declared during the congressional debate that they were both adequately capitalized and had no problem obtaining liquidity. If they were telling the truth, then certainly there was plenty of time for more serious deliberation.

If they were not telling the truth -- and the GSEs just got out of a five-year habit of issuing reports that were late or "qualified" by the auditors -- then Congress just created a blank check for a bailout of two institutions with dubious credibility. Either way, prudence would dictate a little more caution and time should have been taken.

The more plausible reason for the bill's structure is that the decades of coziness between politicians and Fannie and Freddie is paying off. Not only were there campaign contributions, but their "foundations" contributed huge sums to think tanks, and many political figures made the transition from government to the GSEs. The list of their connections reads like a combined Washington-New York phone book, and undoubtedly gives the appearance that both Wall Street and politicians close to Fannie and Freddie had key seats at the bargaining table over this bill. The taxpayer was not adequately represented.

Nor was the homeowner an obvious beneficiary. Both conforming and jumbo mortgage rates have risen about a quarter point during July. The new law actually reduces the amount of competition in the mortgage securitization business going forward by solidifying the special position for the two leading players, Fannie and Freddie, while competitors scramble to get capital.

The legislation also creates long-term uncertainty with regard to the extent and form of government assistance. In effect, Treasury Secretary Paulson now has an open-ended mandate to bail out the nation's troubled housing finance market, the largest single capital market in the world.

If any other country announced that its finance minister could print unlimited debt to do something similar, financial markets around the world would dump both the country's debt and the country's currency. It may well be different because this is the United States of America. But certainly, to take such a risky and unprecedented step, a better crafted and considered piece of legislation should have been created.

Mr. Lindsey, former assistant to the president for economic policy, is president and CEO of the Lindsey Group, and author of "What a President Should Know . . . But Most Learn too Late" (Rowman & Littlefield, 2008).

In my July 29 op-ed ("Obamanomics Is a Recipe for Recession"), I was among the many who took Barack Obama's statements that he would "end the Bush tax cuts for the top incomes" too literally. I interpreted this to mean a return to the pre-Bush tax rates of 39.6% on ordinary income and 20% on capital gains.

The Obama campaign has now clarified that he proposes to do this for labor earnings, but not for capital gains and dividends. I am told that Mr. Obama declared last year that he would raise these rates to "no more than the Reagan rate," by which he apparently means to 28%, from the current 15%. Mr. Obama would thus raise the tax rate on capital gains by about three times as much as President Bush cut it, but he'd preserve at least some of the Bush reduction in the double-taxation of dividends.

(Continued below.)

The 28% rate on capital gains was the price President Ronald Reagan paid to pass the 1986 Tax Reform Act that lowered the top marginal tax rate on ordinary income (including dividends) to 28%. The capital gains rate was cut to 20% in 1997 under President Bill Clinton, and again to 15% in 2003.

However, Mr. Obama is proposing to raise the top marginal rate on wages (also interest, rent and royalties, etc.) more than 40% above the corresponding Reagan rate of 28%. Mr. Obama would thus give us the worst of both worlds: tax rates on ordinary income 40% higher than Reagan and on capital gains 40% higher than Clinton.

Raising the rate on capital gains to 28% would greatly reduce the ability of firms to minimize double taxation by returning cash to their shareholders through repurchases. As for dividends, the Obama plan would nearly double the tax to 28% from 15%.

I have revised the table that accompanied my op-ed showing the negative effects on the after-tax returns on investments to reflect the clarification. It is also available at http://www.stanford.edu/~boskin/. Please use the new table for reference purposes.

I'm glad to hear that Mr. Obama is willing to retain at least a portion of the Bush tax cuts on dividends. But nearly doubling the tax rates on capital gains and dividends to 28% is a terrible idea that would damage fragile financial markets and the economy.

Mr. Boskin is a professor of economics at Stanford University and a senior fellow at the Hoover Institution; he was chairman of the President's Council of Economic Advisers in the George H.W. Bush White House. (The Journal has frequently invited the Obama campaign to explain its tax plans in our pages, and we gladly repeat the invitation publicly here today.)

The most painful and frustrating economic policy blunder of the past 50 years was the Great Inflation of the 1970s. Painful, because it was the catalyst for three damaging recessions (1973-75, 1980, 1981-82), all the while eroding living standards and seriously undermining confidence in America.

It was also deeply frustrating. Despite the teaching of Milton Friedman -- which clearly explained that inflation was caused by too much money chasing too few goods -- a combination of bad economic models, denial and political expediency allowed it to happen.

Corbis President Reagan meets with Paul Volcker, chairman of the Federal Reserve Board, 1981. One would think that the odds of a repeat were low, and for 20 years, after Ronald Reagan and his Fed Chairman Paul Volcker had the courage to get inflation under control with tight money and tax cuts, this was true. Unfortunately, the lessons seem to be fading. Today, the U.S. (and through it the world) faces its greatest threat from inflation in 30 years. And as in the past, this threat is being met with denial and political expediency.

Today's problems began seven years ago in 2001, when the Federal Reserve overreacted to the deflationary mistake it made in the late 1990s. The Fed vigorously pumped money into the economy in order to drive interest rates down rapidly.

As is so often the case, after the Fed has acted, but before the typical lag in monetary policy has fully played out, conventional wisdom argues that the Fed has become impotent. Back in 2002 and 2003, the logic was that the Fed was powerless over globalization, and low-cost labor would continue to feed deflation. In addition, because long-term rates were rising as the Fed cut short-term rates, many thought that markets were undermining Fed intentions.

But, as always, when the Fed injects excess liquidity into the system, inflation begins to rise. As early as 2002, soaring commodity prices and a falling dollar became the canaries in the coal mine of excessively loose monetary policy.

In their wake, almost every measure of inflation in the U.S. has moved significantly higher. In the past year, producer prices have increased 9.2%, while consumer prices are up 5.6%. Yet, because there are so many measures of inflation it is possible to focus on some, for instance consumer prices excluding food and energy (aka, "core" CPI), which remain benign. This allows many to say there is no inflation.

But oil and food are absorbing a large part of excess Fed liquidity. When consumers spend more on energy, they have less to spend in other arenas. This reduces demand for other goods, keeping prices lower than they would be otherwise. This helps explain the divergence between overall and core measures of inflation.

This divergence is now coming to an end. If the recent decline in energy and food prices continues, that money will be released and other prices will start to rise more quickly. The July jump of 0.3% in "core" CPI inflation is likely one of the first signs.

Some argue that the recent drop in commodity prices indicates lessening inflationary pressures. But nothing could be further from the truth. Commodity prices had reached levels that were not justified by current monetary policy. As a result, their pullback is just a correction, not the beginning of a new trend. If this pullback had occurred as the Fed was lifting the federal-funds rate, like back in 1999, it would be a different story. Excluding food and energy from the CPI is sometimes justified because their price movements are often volatile and short-lived. But the five-year average annual growth rate of the CPI, which should smooth out any short run issues, is now 3.6% -- its highest level since 1994. Moreover, the Cleveland Fed's trimmed mean CPI, which excludes the 8% of prices growing the fastest and the 8% growing the slowest, is also up 3.6% in the past year -- its fastest growth since 1991.

When investors hear comparisons of today with the 1970s, they immediately think double-digit inflation. But, it's not that bad -- yet. It took 20 years of accommodative monetary policy in the 1960s and '70s to create the Great Inflation. A more accurate comparison on the inflation front would be the late 1960s, when consumer price inflation accelerated to 6% from about 1%. This period was the precursor of the 1970s. Except for catch-up after the wage and price controls of 1971, the actual move into double-digit inflation did not occur until the late '70s.

With the real (or inflation-adjusted) federal-funds rate now negative, the signals are clear. The Fed is still adding more money to the system than is demanded, and this suggests that the general increase in inflationary pressures will continue. The only question is whether policy makers will get the courage to fight inflation before it gets out of control.

And this is the rub. Much like the 1970s, there is a widespread denial that inflation is a problem today. Some argue that Fed policy is not easy, either because the money supply is not growing, or that banks are deleveraging, which counteracts any attempt by the Fed to inject money.

The first argument hits at the root of Friedman's monetary theory. If money is not growing, then how can inflation be a problem? But money is growing. No measure of money is declining, despite bank deleveraging, and Reserve Bank Credit (the Fed's balance sheet) has expanded at a 14.4% annual rate in the past three months.

Another sign of easy money is that every country that pegs to the dollar, including China and the United Arab Emirates, is experiencing a rapid acceleration in its inflation rates as it imports inflationary U.S. monetary policy.

The second argument is belied by history. Between 1983 and 1994, exactly 2,747 U.S. banks and S&L's failed, representing total assets of $894 billion. During that period of deleveraging, real GDP in the U.S. expanded at an annual average of 3.5%. The Great Depression is the only period of sharp economic contraction in the U.S. correlated with bank failures. But that was clearly related to a deflationary mistake in Fed policy. Real interest rates were outrageously high in the late 1920s, and much of the '30s, which is not true today.

One of the reasons that monetary policy is so loose today is that our economy is addicted once again to easy money and low interest rates. We hear over and over that the Fed cannot tighten because the housing market and the economy are vulnerable. This was the same argument made in the pre-Volcker 1970s, when the U.S. bounced from one economic crisis to the next.

But a look back at the past 40 years clearly shows that the economy was much healthier in the 1980s and '90s, when real interest rates were high, rather than low as they were in the 1960s and '70s.

The Fed's "dual mandate" -- to keep the economy strong and prices stable -- serves to support this mistake. In contrast, the European Central Bank has a single mandate: price stability. No wonder the dollar has been so weak relative to the euro. Imagine two football teams. One with a single mandate: win. The other with a dual mandate: win and keep your uniforms clean. It's clear that the one with the single mandate will have more success in achieving its goals over time.

It is this combination of denial of actual inflation, bad economic models and the political expediency of keeping interest rates low that makes a repeat of past policy mistakes likely. In the end, inflation can be controlled -- the Volcker-Reagan strategy of tight monetary policy and tax cuts still holds the key -- but only if policy makers find the courage.

This from internet friend and superb economist of supply side orientation Scott Grannis:

The NY Times published a lengthy article on Obama's economic policies a few days ago: "How Obama Reconciles Dueling Views on Economy." One friend has summarized the article like this: "Barack Obama, a Free- Market Loving, Big-Spending, Fiscally Conservative Wealth Redistributionist." The article goes to great lengths to sound fair and unbiased, but in typical NYT fashion, it is neither. I've take some time to rebut some of the points raised in the article, since I think it's very important to understand the faulty logic and lack of economic understanding that informs many liberal notions of how weak the economy supposedly is and what the best ways to fix it are.

To begin with, the opening section of this article is just plain wrong about how bad the economy is. A well-respected UCLA professor, Ed Leamer, says that, using the using the criteria developed by the NBER for classifying recessions, the economy is not currently in a recession. In order for this to be a recession, he says, "things would have to get a lot worse." This is hardly a situation where one might claim, as the article does, that "the economy has stopped working."

The article's claim that most families are making less today than they did in 2000 is simply not true, and it is also not true that family income has failed, for the first time, to rise substantially in an economic expansion. Real disposable personal income has risen 17.5% in the current expansion. I'll take that to the bank any day as a sign of progress. This is a shameless misrepresentation of the facts, but it is not surprising given that the article was supposedly fact-checked by the economic geniuses at the NY Times.

The article implies that people have only been able to keep buying things thanks to assuming massive amounts of new debt. But according to the Federal Reserve, debt service burdens for US households (the ratio of debt payments to disposable personal income) have risen from 13.0% to 14.1% in the current expansion. That's not my definition of huge or even significant.

Yes, there are significant debt defaults occurring, but the article neglects to mention one very important fact: a debt default involves a transfer of wealth. The defaulting party is relieved of a debt burden, while the creditor loses a future income stream. In addition, for every house that was bought and financed at the peak of the real estate cycle a few years ago, there was a seller that walked away with a small fortune.

And by all means this remains a very prosperous country. The net worth (total assets minus total liabilities) of US households has risen from $40 trillion in 2001 to almost $60 trillion today. How in the world the NY Times fact-checkers could square that statistic with the doom and gloom in the article is beyond my ability to understand or justify. Even if defaulted mortgages total $1 trillion (way up at the upper end of estimates), that would only equate to less than 2% of households' aggregate net worth.

Then the article goes on to imply that since the economy is already a shambles and McCain's economic policies are basically a rehash of Bush's policies, we can't expect things to get a lot better. Obama "has more-detailed proposals but a less obvious ideology." And that presumably is a good thing.

One of the most important things for Obama is to redistribute income from rich to not-rich, because he believes that income inequality is a new and serious problem, and likely the most serious problem the economy faces today. Yet serious researchers (Alan Reynolds being one) have pointed out that what looks like a growing gap between rich and poor is actually not. And if it looks like the upper income earners have gained a disproportionately larger share of the income pie in the past decade, that overlooks the fact that those who were upper income earners 10 years ago are for the most part not upper income earners today; this is a very fluid economy.

Obama puts income redistribution ahead of deficit reduction. But he also plans to reduce the deficit, mainly by cutting military spending. This was in fact one of the two keys behind Clinton's deficit reduction (the other being a windfall of tax receipts thanks to the tech sector boom). I would simply note that the massive reduction in military spending during the Clinton years left us extremely vulnerable by 2001. I would argue that McCain is the only candidate who can credibly promise to make significant reductions in non-defense spending.

The article praises Obama for his general acceptance of free-market principles that he picked up while at Chicago. But, it gushes, he still realizes that markets aren't perfect and need fixing. This is the position that all liberals are forced to adopt, since free market economies have been wildly successful over time. Critics of the free market point to its failures: budget deficits, income inequality, and the current financial crisis. In essence, this is like saying that you like freedom, but only in limited quantities. Where do you draw the line? In any event, most of the liberal arguments against the free market are based on faulty logic. For example, the deficit has nothing to do with the free market, but everything to do with politicians that can't stop spending money. I've already argued, as have many others, that income inequality is not only misleading, but not even a bad thing to begin with as along as all incomes are rising. The current financial crisis has a lot to do with mistakes made by the Federal Reserve years ago, and to the failure of borrowers to realize that they were paying way too much for their homes and taking on way too much debt in the process. So Obama is going to apply all sorts of remedies for the economy's supposed ills, but he has misdiagnosed the problem. And let's not forget that for every new government program designed to "fix" some supposed failing of the free market, there are at least a few unintended consequences that typically show up.

As a case in point, Obama's tax proposals are designed to reduce the burden of taxes on the lower and middle class, but they would actually make things worse for those people because his proposals will sharply increase marginal tax rates. This will make it much harder for the poor to get rich, a perfect example of unintended consequences to tax- rate engineering. See this article for proof, it is really impressive. "Obama’s give-and-take tax policy results in marginal tax rates of 34 percent to 39 percent in the $31,000 to $45,000 income range for this family. That’s an increase of 13 percentage points or more from the current rates"

Great points made by Scott Grannis on the economic drivel from the NY Times. Writing corrections to MSM is thankless work but someone needs to do it, and more people need to read it IMO.

There seems to be a demographic trend that family sizes are getting smaller with an aging population and more single households. Liberals turn that around to say that family incomes are stagnant, cleverly ignoring - as Grannis points out - a 17.5% increase in real, personal, disposable income. (If two working people marry or divorce, family income is increased by 200% or decreased by 50% but personal income didn't change. They just made different choices.)

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Quoting: "As a case in point, Obama's tax proposals are designed to reduce the burden of taxes on the lower and middle class, but they would actually make things worse for those people because his proposals will sharply increase marginal tax rates. This will make it much harder for the poor to get rich, a perfect example of unintended consequences to tax-rate engineering. See this article for proof, it is really impressive. "

Marc, where he says "See THIS article for proof" I think there was a link in the original that didn't come through. Please post if you have it. TIA.

I’ve spent much of the past year both on Kudlow & Co. and in columns arguing with Jared Bernstein, Robert Reich, Barry Ritholz, Jonathan Chait, and others about whether or not we’re in a recession. These folks (some of whome are members of the “Kudlow Caucus”) were certain we were, while I, along with Larry and other supply-siders, thought we were not. As of this week, and a revised GDP-growth number of 3.3 percent for the second quarter, we now know most authoritatively that the recessionistas were wrong.

Bernstein and Reich, in particular, were flatly wrong. They argued that tax cuts favoring the rich worsened income inequality; that this inequality, coupled with the excessive volatility of free-market capitalism, led to plunging home prices that not only made people feel poorer, but in a reverse “wealth effect” caused a plunge in consumer confidence; and that all this presaged a plunge in consumer spending, which ultimately drove the economy into recession.

The way out of this spiral, they said, can only be a combination of massive government spending and some form of consumer-rebate “stimulus package” to restore spending and, through spending, economic growth. This scenario was, and is, nonsense on stilts.

The housing crisis wasn’t created by free-market capitalism, but by government meddling. In particular, the crisis is rooted in a raft of government regulations that forced banks to ignore traditional lending standards — such as credit history, income, and neighborhood economic conditions — and instead embrace non-culturally “discriminatory” lending practices based on racial-identity politics. Once the banks were forced to make loans based on political, rather than financial, criteria, and once Fannie and Freddie were forced to buy these loans in the secondary mortgage market, collapse was inevitable.

In addition, there is no wealth effect from falling home prices. People generally don’t spend based on the value of their homes, partly because people almost never know the value of their homes. Furthermore, for every seller taking a bath during a down market there is a buyer getting the deal of a lifetime. Predictions about consumer attrition simply have not materialized because, as Milton Freedman taught us, spending patterns are based on long-term income expectations. For this and many other reasons the much-heralded consumer collapse has yet to appear.

Now let’s look at what did happen. The 2003 tax cuts increased wealth in every segment of the economy, sparking a multi-year boom. But these tax cuts were passed with expiration dates, and the first Bush-tax-cut expiration occurred at the end of last year when small businesses lost some of their ability to take a tax deduction on purchases of business equipment. As the chart shows, this event coincided with a trough in the economic cycle. This past winter, congressional Republicans successfully fought to add the small-business tax breaks to what otherwise was a useless stimulus package, and the market for business equipment recovered in the spring. Voilà — the economy snaps back to 3.3 percent GDP growth.

Will the New York Times and the rest of the media storm-crows who spent most of the spring and summer cackling the “recession” word admit their error and reverse course? I think you already know the answer to that question.

It was only a matter of time, unfortunately. And now that Michigan is an election-year swing state and Detroit's auto makers are posting sales declines topping 20% each month, the time has arrived. The issue of a government bailout for General Motors, Ford and Chrysler is moving to center stage.

Barack Obama has said yes to this proposal early on, and last week John McCain climbed on board. So much for change and fighting pork-barrel spending. We're moving beyond moral hazard here, folks, and into a moral quagmire. At least the Chrysler bailout of 1980 was structured so that taxpayers could reap a reward for taking a financial risk on the company's future. That's not what's happening now.

David Gothard Late last year, in its energy bill, Congress authorized $25 billion of low-interest loans to high-risk borrowers -- a strategy perfected by home-mortgage lenders in recent years. In this case the high-risk borrowers are the loss-plagued Detroit car companies. The loans are supposed to help them develop new, fuel-efficient cars, and retool their factories to produce them. Detroit, not being satisfied with this taxpayer largess, wants $50 billion.

This is bad public policy for reasons of philosophy, practicality and precedent. And by the way, this is a dumb idea for the car companies too, simply in terms of their own self-interest.

Philosophically, if the Freddie Mac and Fannie Mae debacles teach us any lesson, it is that subsidizing private profits with public risk is a terrible idea. Implicit government backing has led the managements of these two companies to make reckless investments that have backfired badly. Now government backing has become explicit, and under the plan announced by Treasury Secretary Henry Paulson yesterday, taxpayers likely will pay billions to keep Fannie and Freddie solvent -- with the exact amount uncertain.

The Detroit Three got into their current quandary by making decades of bad decisions, with some help from the United Auto Workers union. Yet despite the current crisis, General Motors is still paying dividends to shareholders, the car companies are paying bonuses to executives, and the private-equity billionaires at Cerberus who bought Chrysler are trying to reap enormous rewards from their risky investment. Meanwhile the UAW's Jobs Bank -- which pays laid-off workers for doing nothing -- remains in place.

Of course, we can all hope that shareholders do well, that executives reap handsome rewards for work well done, that the Cerberus billionaires make more billions on Chrysler, and that workers get paid on whatever terms the car companies agree. But we taxpayers shouldn't subsidize any of this.

The only reason we should bail out any private company is the risk that its demise would wreak havoc on the entire economy. Bear Stearns conceivably passed the test; its collapse could have threatened the U.S. financial system, and the government didn't make the mistake of bailing out shareholders or management.

But just what calamity are we trying to avoid by subsidizing loans to Detroit? That we'll all be sentenced to the indignities of driving Hondas, Mazdas or BMWs? Toyota and Honda, the current leaders in hybrids and alternative-fuel technology, did their research and development on their own dimes.

Even if Ford, GM and Chrysler were to go out of business -- and it's highly unlikely that all three will simply cease to exist -- there will be plenty of good cars for Americans to buy. And many will be made in America, even if they carry foreign nameplates. Toyota, Nissan, Honda, Hyundai and other foreign car companies have expanded greatly their U.S. manufacturing operations in recent years. They're doing so because Americans are buying their cars.

As a practical matter, Americans could choose to buy more Detroit cars. Frankly, they should -- considering such outstanding products as the Ford Focus, a fuel-efficient and comfortable compact, and the Chevrolet Malibu, a terrific new mid-sized sedan. But they're not. Americans are voting with their dollars, which is their right.

And what about the precedent the government would set? If we bail out Detroit, where do we stop? The newspaper industry is in financial trouble because more readers and advertisers are turning to the Internet. Newspapers are good for democracy -- Thomas Jefferson said he would choose newspapers over government, after all -- so shouldn't they get low-interest government loans to help them adjust to the Internet? Of course not, and ditto for Detroit.

If Detroit's auto makers would apply more than knee-jerk analysis to what's being proposed, they would reject it quickly. No matter what their spin, including the patently absurd claim that government-guaranteed, below-market loans aren't a bailout, loan subsidies will paint them in the public mind as corporate welfare recipients that can't compete on their own. That can't be good for sales.

More fundamentally, the last thing these companies need just now is more debt. They are leveraged to the hilt, and risk climbing into a financial hole from which they'll never recover. Better to raise money by selling more assets (e.g., Ford's recent sale of Jaguar and Land Rover) or raising more equity -- even if new investors would require management changes or other measures.

All this said, if Detroit's short-sightedness and political expediency make a bailout inevitable, let's make sure taxpayers stand to get rewarded for their risk. In 1980, the government didn't lend any money directly to Chrysler, instead guaranteeing loans to the company made by private lenders, mostly banks, in the amount of $1.2 billion (bailouts, like everything else, were cheaper back then). But in return, the government got warrants to buy Chrysler stock at a very low price. When Chrysler staged its spectacular recovery and paid off the bank loans seven years early, the warrants soared in value and the government earned some $400 million.

Then CEO Lee Iacocca tried to get the government to forego its profits -- he even got into a telephone shouting match with Treasury Secretary Donald Regan. But Regan, backed by President Reagan, stuck to his guns.

One other stipulation: any low-interest loans to develop fuel-efficient cars should be made available to all car companies, not just the Detroit Three. The law passed by Congress last year is framed to make this highly unlikely. But if developing fuel-efficient and alternative-energy cars is deemed worthy of taxpayer subsidies for public-policy purposes, it's just common sense not to put all our eggs in Detroit's basket.

Mr. Ingrassia, a former Detroit bureau chief for this newspaper, won a Pulitzer Prize in 1993 for his automotive coverage. He writes on automotive issues for The Journal, Condé Nast Portfolio and other publications.

The Spending ExplosionSeptember 10, 2008; Page A14Here's a prediction: The media will report today that the federal budget deficit is big and getting bigger. What most of them won't report, alas, is that the cause of these deficits is an explosion in federal spending. The era of big government is back, bigger than ever.

The real news in yesterday's Congressional Budget Office semiannual report is that federal expenditures on everything from roads to homeland security to health care will on present trends reach 21.5% of GDP next year. That's a larger share of national output than at anytime since 1992. If the cost of the federal takeover of Fannie Mae and Freddie Mac prove to be large and are taken into account, next year federal outlays could be higher as a share of the economy than at anytime since World War II. In this decade alone, federal spending has increased by almost $1.2 trillion, or 57%.

The federal deficit is expected to hit $407 billion for fiscal 2008 (which ends at the end of this month) and $438 billion next year. Still, the deficit is expected to be only 3% of GDP, which is in line with the average of the last 30 years. We hope Congress and the Presidential candidates don't obsess over the deficit per se, because the real fiscal drag from government comes from how much it spends, not how much it borrows.

The Bush tax cuts also aren't the budget problem. Until this year federal tax collections have been surging. In the four years after the 2003 tax cuts become law, tax receipts exploded by $785 billion. This year revenues have declined by 0.8%, but a major reason is the $150 billion bipartisan tax rebate that has hit the Treasury without spurring the economy. Without these nonstimulating rebates, federal tax payments would have climbed another 2.5%, according to CBO. Revenue is expected to be a healthy 18.5% of GDP next year without any tax increase.

Another myth is that the war on terror has busted the budget. While operations in Iraq and Afghanistan are expensive, defense spending is $605 billion this year, or about 4.5% of GDP. That only seems large by comparison to the holiday from history of the 1990s, when defense fell to 3% of GDP. As recently as 1986, defense spending was 6.2% of GDP.

The real runaway train is what CBO calls a "substantial increase in spending" that is "on an unsustainable path." That's for sure. The nearby chart shows how much some federal accounts have expanded since 2001, and in inflation-adjusted dollars. This year alone, federal agencies have lifted their spending by 8.1%, with another 7% raise expected for 2009. There's certainly no recession in Washington. The CBO says that, merely in the two years that Democrats have run Congress, federal expenditures are up $429 billion -- to $3.158 trillion.

The fiscal blowouts have included a record farm bill, notwithstanding record farm income; an aid bill for distressed homeowners, extended unemployment benefits, and more generous veterans benefits. Next up: votes on $50 billion for Detroit auto firms, an $80 billion energy bill, as much as $50 billion for spending masked as a "second stimulus," plus $100 billion or more for the Fannie and Freddie rescue. Rather than sort through priorities, Congress is spending more on just about everything.

Meanwhile, remember that "pay as you go" spending promise that Speaker Nancy Pelosi made in 2006? We called it a ruse at the time, and the last two years have proved it. Senator Judd Gregg (R., N.H.) has tallied up at least $398 billion in "paygo" violations so far. Earmarks were also supposed to be cut in half by this Congress. In 2008 there were some 11,000 at a cost of $17 billion, the second most ever, and far more than half the peak of 14,000 in 2006.

The point to keep in mind is that this big spending blitz is coming even before a new President and Congress arrive next year with far more spending promises in tow. As they contemplate their choice for President, voters might want to consider which of the candidates is likely to be a check on Congressional appetites, rather than a facilitator.

Are You Ready for a BailoutMatthew Swibel, 09.10.08, 6:00 AM ETCall it a Washington pile-on.

A normal taxpayer might think that since the Treasury Department has just committed the government to spending an unknown (but possibly very large) amount taking over Fannie Mae and Freddie Mac, Congress would be in a tightfisted mood.

But that's not the way some Washington lobbyists and politicians think. Instead, they're viewing the bailout as an invitation to push through other taxpayer-financed bailouts and aid in the few weeks that Congress will work before members break to campaign full time for the November elections.

"We're talking about the next New Deal," enthuses William McNary, president of USAction, a national coalition of grass-roots community organizers. He wants more money from Congress for everything from food stamps to inspecting and fixing bridges and roads.

U.S. automakers General Motors, Ford Motor and Chrysler, for their part, are pushing Congress to appropriate by the end of this month $3.75 billion of $25 billion in loans authorized last December to help the money-bleeding companies overhaul their plants so they can build more fuel-efficient vehicles.

They want another $25 billion in low-cost loans authorized for when they've run through the first $25 billion. Pete Davis, president of Davis Capital Investment Ideas, predicts the government's budget wonks will estimate that the added $25 billion loan package will cost taxpayers $900 million.

Hey, that's less than $1 billion. Plus, it will play well politically in Michigan, where more than 260,000 manufacturing jobs have been lost since 2000, and in Detroit, where one in every 10 workers is without a job.

Meanwhile, Democrats in Congress are itching to pass a second economic stimulus package to benefit American consumers before they make their way to the ballot box--except that it won't go directly into Americans' bank accounts this time around, as it did with the tax rebates in round one.

Reports say the measure, not written yet, will total $50 billion in the form of grants to help state and local governments with infrastructure projects, Medicaid costs and local law enforcement, as well as relief for Gulf Coast residents struggling with flood costs and those in the Northeast and upper Midwest straining to pay winter heating bills.

Politics plays a part in this of course. "I got a four-letter word: j-o-b-s," said U.S. Rep. Rahm Emanuel, D-Ill. "That's the focus of the second stimulus. We want to own the issue that we are the party of a jobs agenda. We will take it up as soon as we are done with the energy bill."

But the demand for more infrastructure spending isn't coming from just Democrats. Desmond Lachmann, a resident fellow from the conservative American Enterprise Institute, has advocated it too.

Also with her hand out is Bush administration Transportation Secretary Mary Peters, who told Congress last week she wants it to inject $8 billion into the federal Highway Trust Fund. The trust's main source of funding is the flat, 18.4-cents-per-gallon gas tax. The rising price of gas has led Americans to drive tens of billions of miles less this year--meaning less money going into the trust fund.

All this is in addition to the $70 billion to $100 billion that Congress is expected to pass in supplemental funding for the wars in Iraq and Afghanistan.

Then, of course, there's the Fannie and Freddie rescue. The Congressional Budget Office estimates the bailout could cost taxpayers $25 billion in the long run. But rescuing the mortgage giants--which together have roughly $6 trillion in liabilities--might also cost zilch. Or, if the housing market worsens, the bill could be much bigger.

William Poole, former president of the Federal Reserve Bank of St. Louis, calculates that should Fannie's and Freddie's loan books suffer 5% losses, the bailout would cost the taxpayers about $300 billion.

"What makes me laugh – ruefully, I assure you – is when our office seekers trot around the country promising “accountability” for Wall Street. Lehman just went bankrupt – in a market economy, things don’t get more “accountable” than that."

2) Money will be put to use. It does not wind up in enormous mattresses gathering dust. After all the smart uses were exhausted, Wall Street began looking to dumbers uses, or riskier uses if you will. Foremost among these riskier uses was issuing subprime mortgages.

3) The availability of subprime mortgages had two immediate effects. First, it created a whole new class of potential homeowners. As this new class of homeowners drove demand through the roof, the value of your house (and mine) increased dramatically.

4) Unfortunately for everyone involved, a lot of these people defaulted on their subprime loans. Thus, the subprime mortgage market disappeared while foreclosed homes glutted the housing market. That meant a sharp decline in demand and a sharp increase in supply hit the housing market simultaneously, making the value of your house (and mine) decrease dramatically. In terms of where this crisis hits the typical American, this item is the bogey. The typical American lost a huge chunk of his net worth thanks to the housing crisis, and it won't fully bounce back until…well, nobody knows when.

5) The erstwhile homeowners who took out loans they couldn’t afford lost their homes and faced financial ruin. The firms who issued subprime loans and the firms who purchased subprime mortgage backed securities that the erstwhile homeowners couldn’t make good on also faced financial ruin.

So what can the government and its various agencies do in such a situation? Fannie and Freddie had to be saved – “too big to fail” was right, and that’s what made the shenanigans of those quasi-governmental agencies so scandalous. But Lehman? Life and the economy will go one.

Fed Governors will study for years the original Greenspan sins that set this course of events in motion. Meanwhile, Greenpsan will probably be taking to the airwaves to defend his tattered legacy. As far as the subprime lending industry that proximately triggered the crisis, theoretically the government in the future could set up a regulatory regime that puts mortgages out of reach for certain risky home buyers. Happily, I bet that idea sounds as noxious to liberals as it does to conservatives.

So government and politicians can only do what they do best – blindly cast blame on a matter that they don’t fully understand. Let’s not forget we have two presidential candidates who have spent a combined fifteen minutes in the private sector. I would love to see Charlie Gibson have a few minutes on camera with Barack Obama and ask in his impatient schoolmarm way, “Exactly what did Lehman Brothers do on a day in/day out basis?” I would expect an irrelevant homily on the virtues of “Main Street” as opposed to “Wall Street” in response.

In a free market, good decisions will be rewarded and poor decisions will be punished. That happens at the individual level when a person takes a mortgage that they can’t afford. And it happens at a bigger level when a company like Lehman pursues an “aggressive” strategy that ultimately proves imprudent.

What makes me laugh – ruefully, I assure you – is when our office seekers trot around the country promising “accountability” for Wall Street. Lehman just went bankrupt – in a market economy, things don’t get more “accountable” than that.

What everyone wants to know is how serious the current situation is. Step back from the ledge, and for goodness sakes ignore Senator Obama’s ignorant hysterics. What we have now is a market correction. Firms that made poor decisions are being devoured by the market’s unforgiving nature. Today the Dow is steady, the American economy having easily withstood the shock of the weekend’s events. Most salubriously, the moral hazard that the government sponsored with past bailouts and craven enabling (see Fannie and Freddie) is now a memory. In evaluating future risks, finance houses will no longer consider the moving target of federal intervention if/when things don’t work out.

The weekend’s events were terrible news for Lehman’s employees not to mention the countless vendors who depended on the firm. The bad news also extends to New York City, which will have the burden of a moribund financial sector to lug around for the foreseeable future. It stinks that things work out this way sometimes. But so it goes in a free market economy.

“[Barack] Obama... blamed the shocking new round of subprime-related bankruptcies on the free-market system, and specifically the ‘trickle-down’ economics of the Bush administration, which he tried to gig opponent John McCain for wanting to extend. But it was the Clinton administration, obsessed with multiculturalism, that dictated where mortgage lenders could lend, and originally helped create the market for the high-risk subprime loans now infecting like a retrovirus the balance sheets of many of Wall Street’s most revered institutions. Tough new regulations forced lenders into high-risk areas where they had no choice but to lower lending standards to make the loans that sound business practices had previously guarded against making. It was either that or face stiff government penalties. The untold story in this whole national crisis is that President Clinton put on steroids the Community Redevelopment Act, a well-intended Carter-era law designed to encourage minority homeownership. And in so doing, he helped create the market for the risky subprime loans that he and Democrats now decry as not only greedy but ‘predatory.’ Yes, the market was fueled by greed and overleveraging in the secondary market for subprimes, vis-a-vis mortgaged-backed securities traded on Wall Street. But the seed was planted in the ‘90s by Clinton and his social engineers.” —Investor’s Business Daily

A friend serving in the Bush administration called Sunday to try to talk me out of my doubts about the $700 billion financial bailout the administration was asking Congress to approve. I picked up the phone, and made the mistake of good-naturedly remarking, in my best imitation of Oliver Hardy, “Well, this is a fine mess you’ve gotten us into.”

People who’ve been working 18-hour days trying to avert a meltdown are entitled to bristle at jocular comments from those of us not in public office. So he bristled. He then tried to persuade me that the only responsible course of action was to support the administration’s request.

I’m not convinced.

It’s not that I don’t believe the situation is dire. It’s not that I want to insist on some sort of ideological purity or free-market fastidiousness. I will stipulate that this is an emergency, and is a time for pragmatic problem-solving, perhaps even for violating some cherished economic or political principles. (What are cherished principles for but to be violated in emergencies?)

And I acknowledge that there are serious people who think the situation too urgent and the day too late to allow for a real public and Congressional debate on what should be done. But — based on conversations with economists, Wall Street types, businessmen and public officials — I’m doubtful that the only thing standing between us and a financial panic is for Congress to sign this week, on behalf of the American taxpayer, a $700 billion check over to the Treasury.

A huge speculative housing bubble has collapsed. We’re going to have a recession. Unemployment will go up. Credit is going to be tighter. The challenge is to contain the damage to a “normal” recession — and to prevent a devastating series of bank runs, a collapse of the credit markets and a full-bore depression.

Everyone seems to agree on the need for a big and comprehensive plan, and that the markets have to have some confidence that help is on the way. Funds need to be supplied, trading markets need to be stabilized, solvent institutions needs to be protected, and insolvent institutions need to be put on the path to a deliberate liquidation or reorganization.

But is the administration’s proposal the right way to do this? It would enable the Treasury, without Congressionally approved guidelines as to pricing or procedure, to purchase hundreds of billions of dollars of financial assets, and hire private firms to manage and sell them, presumably at their discretion There are no provisions for — or even promises of — disclosure, accountability or transparency. Surely Congress can at least ask some hard questions about such an open-ended commitment.

And I’ve been shocked by the number of (mostly conservative) experts I’ve spoken with who aren’t at all confident that the Bush administration has even the basics right — or who think that the plan, though it looks simple on paper, will prove to be a nightmare in practice.

But will political leaders dare oppose it? Barack Obama called Sunday for more accountability, and I imagine he’ll support the efforts of the Democratic Congressional leadership to try to add to the legislation a host of liberal spending provisions. He probably won’t want to run the risk of actually opposing it, or even of raising big questions and causing significant delay — lest he be attacked for risking the possible meltdown of the global financial system.

What about John McCain? He could play it safe, going along with whatever the Bush administration and the Congress are able to negotiate.

If he wants to be critical, but concludes that Congress has to pass something quickly lest the markets fall apart again, and that he can’t reasonably insist that Congress come up with something fundamentally better, he could propose various amendments insisting on much more accountability and transparency in how Treasury handles this amazing grant of power.

Comments by McCain on Sunday suggest he might propose an amendment along the lines of one I received in an e-mail message from a fellow semi-populist conservative: “Any institution selling securities under this legislation to the Treasury Department shall not be allowed to compensate any officer or employee with a higher salary next year than that paid the president of the United States.” This would punish overpaid Wall Streeters and, more important, limit participation in the bailout to institutions really in trouble.

Or McCain — more of a gambler than Obama — could take a big risk. While assuring the public and the financial markets that his administration will act forcefully and swiftly to deal with the crisis, he could decide that he must oppose the bailout as the panicked product of a discredited administration, an irresponsible Congress, and a feckless financial establishment, all of which got us into this fine mess.

Critics would charge that in opposing the bailout, in standing against an apparent bipartisan consensus, McCain was being irresponsible.

I usually find Krugman to be an ass, an idiot, or both-- but here I think he raises some fair questions.

Cash for Trash PAUL KRUGMANPublished: September 21, 2008 NY Times

Some skeptics are calling Henry Paulson’s $700 billion rescue plan for the U.S. financial system “cash for trash.” Others are calling the proposed legislation the Authorization for Use of Financial Force, after the Authorization for Use of Military Force, the infamous bill that gave the Bush administration the green light to invade Iraq.

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Paul Krugman

Back Story with Paul Krugman (mp3)Readers' CommentsShare your thoughts on this article.Post a Comment »There’s justice in the gibes. Everyone agrees that something major must be done. But Mr. Paulson is demanding extraordinary power for himself — and for his successor — to deploy taxpayers’ money on behalf of a plan that, as far as I can see, doesn’t make sense.

Some are saying that we should simply trust Mr. Paulson, because he’s a smart guy who knows what he’s doing. But that’s only half true: he is a smart guy, but what, exactly, in the experience of the past year and a half — a period during which Mr. Paulson repeatedly declared the financial crisis “contained,” and then offered a series of unsuccessful fixes — justifies the belief that he knows what he’s doing? He’s making it up as he goes along, just like the rest of us.

So let’s try to think this through for ourselves. I have a four-step view of the financial crisis:

1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately comes from mortgage payments.

2. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt. This problem is especially severe because everyone took on so much debt during the bubble years.

3. Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.

4. Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the “paradox of deleveraging.”

The Paulson plan calls for the federal government to buy up $700 billion worth of troubled assets, mainly mortgage-backed securities. How does this resolve the crisis?

Well, it might — might — break the vicious circle of deleveraging, step 4 in my capsule description. Even that isn’t clear: the prices of many assets, not just those the Treasury proposes to buy, are under pressure. And even if the vicious circle is limited, the financial system will still be crippled by inadequate capital.

Or rather, it will be crippled by inadequate capital unless the federal government hugely overpays for the assets it buys, giving financial firms — and their stockholders and executives — a giant windfall at taxpayer expense. Did I mention that I’m not happy with this plan?

The logic of the crisis seems to call for an intervention, not at step 4, but at step 2: the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.

That’s what happened in the savings and loan crisis: the feds took over ownership of the bad banks, not just their bad assets. It’s also what happened with Fannie and Freddie. (And by the way, that rescue has done what it was supposed to. Mortgage interest rates have come down sharply since the federal takeover.)

But Mr. Paulson insists that he wants a “clean” plan. “Clean,” in this context, means a taxpayer-financed bailout with no strings attached — no quid pro quo on the part of those being bailed out. Why is that a good thing? Add to this the fact that Mr. Paulson is also demanding dictatorial authority, plus immunity from review “by any court of law or any administrative agency,” and this adds up to an unacceptable proposal.

I’m aware that Congress is under enormous pressure to agree to the Paulson plan in the next few days, with at most a few modifications that make it slightly less bad. Basically, after having spent a year and a half telling everyone that things were under control, the Bush administration says that the sky is falling, and that to save the world we have to do exactly what it says now now now.

But I’d urge Congress to pause for a minute, take a deep breath, and try to seriously rework the structure of the plan, making it a plan that addresses the real problem. Don’t let yourself be railroaded — if this plan goes through in anything like its current form, we’ll all be very sorry in the not-too-distant future.

***It would enable the Treasury, without Congressionally approved guidelines as to pricing or procedure, to purchase hundreds of billions of dollars of financial assets, and hire private firms to manage and sell them, presumably at their discretion There are no provisions for — or even promises of — disclosure, accountability or transparency***

Well that would be nuts. One could only imagine the billions that would be stolen.

Once upon a time, in the land that FDR built, there was the rule of "regulation" and all was right on Wall and Main Streets. Wise 27-year-old bank examiners looked down upon the banks and saw that they were sound. America's Hobbits lived happily in homes financed by 30-year-mortgages that never left their local banker's balance sheet, and nary a crisis did we have.

Then, lo, came the evil Reagan marching from Mordor with his horde of Orcs, short for "market fundamentalists." Reagan's apprentice, Gramm of Texas and later of McCain, unleashed the scourge of "deregulation," and thus were "greed," short-selling, securitization, McMansions, liar loans and other horrors loosed upon the world of men.

Now, however, comes Obama of Illinois, Schumer of New York and others in the fellowship of the Beltway to slay the Orcs and restore the rule of the regulator. So once more will the Hobbits be able to sleep peacefully in the shire.

APFrom left: Christopher Cox, Henry Paulson, Harry Reid, Richard Shelby, Nancy Pelosi, Chris Dodd and Ben Bernanke.With apologies to Tolkien, or at least Peter Jackson, something like this tale is now being sold to the American people to explain the financial panic of the past year. It is truly a fable from start to finish. Yet we are likely to hear some version of it often in the coming months as the barons of Congress try to absolve themselves of any responsibility for the housing and mortgage meltdowns.

Yes, greed is ever with us, at least until Washington transforms human nature. The wizards of Wall Street and London became ever more inventive in finding ways to sell mortgages and finance housing. Some of those peddling subprime loans were crooks, as were some of the borrowers who lied about their incomes. This is what happens in a credit bubble that becomes a societal mania.

A Look Back at the Crisis UnfoldingStopping the Panic 09/20/08 – Now the task is to protect taxpayers and restore markets.Be It Resolved 09/19/08 – Paulson and Bernanke ask Congress for a resolution agency.The Fed and AIG 09/18/08 – Nationalizations aren't stopping the financial panic.McCain and the Markets 09/17/08 – Denouncing 'greed' and Wall Street isn't a growth agenda.The Fed's Epic Day 09/17/08 – It's only fair to praise the central bank when it does the right thing.Surviving the Panic 09/16/08 – A resolution agency, steady monetary policy, and a big tax cut.Wall Street Reckoning 09/15/08 – Treasury Secretary Hank Paulson's refusal to blink won't get any second guessing from us.But Washington is as deeply implicated in this meltdown as anyone on Wall Street or at Countrywide Financial. Going back decades, but especially in the past 15 or so years, our politicians have promoted housing and easy credit with a variety of subsidies and policies that helped to create and feed the mania. Let us take the roll of political cause and financial effect:

- The Federal Reserve. The original sin of this crisis was easy money. For too long this decade, especially from 2003 to 2005, the Fed held interest rates below the level of expected inflation, thus creating a vast subsidy for debt that both households and financial firms exploited. The housing bubble was a result, along with its financial counterparts, the subprime loan and the mortgage SIV.

Fed Chairmen Alan Greenspan and Ben Bernanke prefer to blame "a global savings glut" that began when the Cold War ended. But Communism was dead for more than a decade before the housing mania took off. The savings glut was in large part a creation of the Fed, which flooded the world with too many dollars that often found their way back into housing markets in the U.S., the U.K. and elsewhere.

- Fannie Mae and Freddie Mac. Created by government, and able to borrow at rates lower than fully private corporations because of the implied backing from taxpayers, these firms turbocharged the credit mania. They channeled far more liquidity into the market than would have been the case otherwise, especially from the Chinese, who thought (rightly) that they were investing in mortgage securities that were as safe as Treasurys but with a higher yield.

These are the firms that bought the increasingly questionable mortgages originated by Angelo Mozilo's Countrywide and others. Even as the bubble was popping, they dived into pools of subprime and Alt-A ("liar") loans to meet Congressional demand to finance "affordable" housing. And they were both the cause and beneficiary of the great interest-group army that lobbied for ever more housing subsidies.

Fan and Fred's patrons on Capitol Hill didn't care about the risks inherent in their combined trillion-dollar-plus mortgage portfolios, so long as they helped meet political goals on housing. Even after taxpayers have had to pick up a bailout tab that may grow as large as $200 billion, House Financial Services Chairman Barney Frank still won't back a reduction in their mortgage portfolios.

- A credit-rating oligopoly. Thanks to federal and state regulation, a small handful of credit rating agencies pass judgment on the risk for all debt securities in our markets. Many of these judgments turned out to be wrong, and this goes to the root of the credit crisis: Assets officially deemed rock-solid by the government's favored risk experts have lately been recognized as nothing of the kind.

When debt instruments are downgraded, banks must then recognize a paper loss on these assets. In a bitter irony, the losses cause the same credit raters whose judgments allowed the banks to hold these dodgy assets to then lower their ratings on the banks, requiring the banks to raise more money, and pay more to raise it. The major government-anointed credit raters -- S&P, Moody's and Fitch -- were as asleep on mortgages as they were on Enron. Senator Richard Shelby (R., Ala.) tried to weaken this government-created oligopoly, but his reforms didn't begin to take effect until 2007, too late to stop the mania.

- Banking regulators. In the Beltway fable, bank supervision all but vanished in recent years. But the great irony is that the banks that made some of the worst mortgage investments are the most highly regulated. The Fed's regulators blessed, or overlooked, Citigroup's off-balance-sheet SIVs, while the SEC tolerated leverage of 30 or 40 to 1 by Lehman and Bear Stearns.

The New York Sun reports that an SEC rule change that allowed more leverage was made in 2004 under then Chairman William Donaldson, one of the most aggressive regulators in SEC history. Of course the SEC's task was only to protect the investor assets at the broker-dealers, not the holding companies themselves, which everyone thought were not too big to fail. Now we know differently (see Bear Stearns below).

Meanwhile, the least regulated firms -- hedge funds and private-equity companies -- have had the fewest problems, or have folded up their mistakes with the least amount of trauma. All of this reaffirms the historical truth that regulators almost always discover financial excesses only after the fact.

- The Bear Stearns rescue. In retrospect, the Fed-Treasury intervention only delayed a necessary day of reckoning for Wall Street. While Bear was punished for its sins, the Fed opened its discount window to the other big investment banks and thus sent a signal that they would provide a creditor safety net for bad debt.

Morgan Stanley, Lehman and Goldman Sachs all concluded that they could ride out the panic without changing their business models or reducing their leverage. John Thain at Merrill Lynch was the only CEO willing to sell his bad mortgage paper -- at 22 cents on the dollar. Treasury and the Fed should have followed the Bear trauma with more than additional liquidity. Once they were on the taxpayer dime, the banks needed a thorough scrubbing that might have avoided last week's stampede.

- The Community Reinvestment Act. This 1977 law compels banks to make loans to poor borrowers who often cannot repay them. Banks that failed to make enough of these loans were often held hostage by activists when they next sought some regulatory approval.

Robert Litan, an economist at the Brookings Institution, told the Washington Post this year that banks "had to show they were making a conscious effort to make loans to subprime borrowers." The much-maligned Phil Gramm fought to limit these CRA requirements in the 1990s, albeit to little effect and much political jeering.

We could cite other Washington policies, including the political agitation for "mark-to-market" accounting that has forced firms to record losses after ratings downgrades even if the assets haven't been sold. But these are some of the main lowlights.

Our point here isn't to absolve Wall Street or pretend there weren't private excesses. But the investment mistakes would surely have been less extreme, and ultimately their damage more containable, if not for the enormous political support and subsidy for mortgage credit. Beware politicians who peddle fables that cast themselves as the heroes.